Why do buyers pay for control?

Does the price of a public company’s shares reflect a minority interest or pro-rata share of the value of a business as a whole?

Is it appropriate to directly apply an incremental “control premium” to arrive at the value of a business as a whole?

Does market evidence derived by comparison of an acquisition price (of a public company) to its pre-transaction publicly-traded price represent a premium for control? Does this market evidence represent “control” or something else (e.g. buyer-specific synergies)?

When valuing a business, determining the control premium is a significant, and often controversial, issue. Historically, there has been significant diversity in practice in adjusting business value to reflect the benefits of control. Some believe an incremental premium should always be applied while others believe that control premiums are applicable in only limited situations. To address this diversity in practice, the Appraisal Foundation’s Working Group on Control Premiums issued a discussion draft titled The Measurement and Application of Market Participant Acquisition Premiums.

The Working Group utilized the term “market participant acquisition premium” (“MPAP”) for two primary reasons: 1) to stress the concept of a market participant perspective, and 2) to differentiate this concept from the more widely recognized concept of the control premium utilized in tax and litigation settings. This document is intended to provide guidance in determining the fair value of a controlling interest in a business.

Defining the MPAP

The Working Group identified two primary factors influencing the fair value of a controlling interest: 1) improved cash flow; and, 2) risk reduction. These factors drive any incremental economic benefits resulting from the acquisition of the company. Market participants can often generate improved cash flow in the form of synergies such as the elimination of duplicative overhead. In terms of risk reduction, the combination of the merged/acquired company may reduce the company’s risk profile.

The document suggests that a buyer would not pay a premium for outright control in the absence of opportunities for cash flow enhancement or risk reduction. The implication of this argument is that a company’s public share price may, in some instances, reflect a pro-rata share of the “control” value of the business (if no incremental economic benefits would be available to a buyer). This is in contrast to the view that there is inherent value to having outright control of a company (regardless of any incremental economic benefits). It is also important to note that market participants will not always incorporate all economics of control into the price paid for a controlling interest. A market participant is willing to pay no more than necessary to outbid the next highest bidder.

Impairment Testing

The implications for goodwill impairment testing are notable. Questions often arise as to whether the fair value of the reporting unit reflects a control-basis value, or if an additional premium is appropriate to reflect the additional price that a market participant would pay to gain control of a company. In practice, the following factors should be considered when performing a goodwill impairment test:

• Enhanced cash flows. The forecast for the reporting unit(s) should reflect the synergies available to market participants (commonly in the form of elimination of corporate overhead).
• Risk reduction. The discount rate should reflect the risk profile of the reporting unit from a market participantæ perspective. This is often lower than the risk of the reporting unit on a stand-alone basis due to optimized capital structure, reduced operating risk, diversification, etc.
• Implied premium (MPAP). The MPAP is an implied premium, as opposed to a direct incremental adjustment (traditional “control premium”) to the resultant value of the business as a whole. This implied premium should reflect the risk reduction or cash flow enhancement available to market participants. As such, no incremental premium is appropriate.
• Invested Capital vs. Equity Foundation. The Working Group also indicates that best practices include expressing/determining the MPAP on an invested capital basis (as opposed to an equity basis). This is better aligned with the factors contributing to the MPAP (cash flow enhancementæand risk reduction), thus eliminating the impact of differing capital structures.
• Market Cap Reconciliation. For publicly traded entities, it is often useful to perform a comparison of market capitalization (or market-implied enterprise value) to the sum of the fair value of the reporting units. Reasonableness of the implied MPAP should be explained in terms of risk reduction or cash flow enhancement from the perspective of market participants.
• The larger the MPAP, the higher the auditor scrutiny. In impairment testing, sensitivity around the “cushion” (the amount by which the fair value of the reporting unit exceeds the carrying value) is often a significant discussion point in the audit. To the extent that the implied MPAP is a determining factor in the conclusion of a Step 1 analysis (impairment/no impairment), additional support is often required.

The Appraisal Foundation’s recent discussion draft provides new guidance as to consideration of an MPAP in fair value measurements. It confirms the concept that the MPAP should be an implied premium and explained by the cash flow enhancement or risk reduction available to market participants. As noted, it has particular importance in impairment testing where the determination of the appropriate MPAP may be a critical issue to the company, its auditors and other stakeholders. For more information, contact your VRC representative.