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The article in brief:
- COVID-19 is impacting global markets and triggering a potential for interim goodwill impairment testing.
- In light of the current market downturn, can we anticipate the impact on control premiums?
- VRC analyzed control premium data vs. the DJIA over the 24-years from 1996 through 2019, to understand how sharp changes in the stock market impacted control premiums.
How do significant changes in the stock market impact control premiums?
With COVID-19 impacting stock markets around the world, and triggering companies to contemplate the possibility of goodwill impairment, VRC examined how control premiums change throughout market life cycles, and why.
What are Control Premiums?
Control premiums are the premium paid by a buyer over and above an estimated prevailing market price to acquire a target company. Control premiums are also referred to as a “market participant acquisition premium” (MPAP), and can reflect many items, including, but not limited to:
- The intrinsic value of the firm,
- Synergies available to the acquiring company, or
- Overpayment, in some cases.
Due to these factors, there has historically been significant diversity in estimating company values to reflect the benefits of control.
Defining the MPAP
The two primary factors influencing the fair value of a controlling interest, improved cash flows and risk reduction, drive the incremental economic benefits resulting from acquisitions. Market participants can often generate improved cash flow in the form of synergies, such as the elimination of duplicative overhead or enhanced cross-selling opportunities. From a risk reduction perspective, the merged/acquired company could also generate competitive advantages, such as reducing the bargaining power of buyers or suppliers, which could reduce the company’s risk profile.
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 premium a market participant would pay to gain control of a company.
Valuation analysis is a holistic process where there are many interdependent factors. Therefore, the implied premium should reflect macro factors such as the impact on specific industries, and micro factors such as risk reduction and cash flow enhancement available, and avoid any double-counting. The larger the implied premium, generally, the higher the auditor scrutiny. In impairment testing, sensitivity around the “cushion” (the amount the fair value exceeds the carrying value) is often a significant discussion point in the audit.
Market Index Impacts on Control Premium
VRC reviewed average and median control premium data and the Dow Jones Industrial Average (DJIA) over 24-years from 1996 to 2019. Control premiums reflect the excess amount paid by an acquiring company over the current stock price (or 30- or 60-day average) of the target company.
In the observed range from 1996 to 2019, median control premiums generally fell into a range of 20 to 30 percent, with an observed peak of over 50 percent in 2010. Following this peak, control premiums declined steadily until 2013 and remained low until 2019 amid a decade-long bull run in the equity markets.
In general, it is our view that that control premiums generally follow an inverse relationship to public markets – as equity values rise, control premiums tend to decrease. In contrast, as equity values fall, control premiums seem to rise.
In the observed range from 1996 to 2019, median control premiums generally fell into a range of 20 to 30 percent, with an observed peak of over 50 percent in 2010.
Detailing Our Analysis
Average control premiums tend to fluctuate more significantly as a few large deals can have a material impact. Using historical examples, we observe that the timing of control premiums relative to the DJIA is mixed, sometimes responding immediately, other times taking a year to hit their peak or bottom. We determine this is likely a result of a difference in the consensus view of the market, the time frame of the market correction, the timeliness of completed deals, and limitations of the data being reviewed.
Another volatile period for control premiums was between 1997 and 2003. During the time leading up to this period, control premium medians hovered around 23 percent. However, indices fell sharply from April 2000 through March of 2003 as a result of the burst of the dot.com bubble and the subsequent 9/11 attacks. As markets declined, control premium medians climbed to a range of 25 to 35 percent.
In the years leading up to the housing bubble and the financial crisis, control premiums and equities rose as the economy boomed. However, the sharp decline in equities during the financial crisis and the Great Recession resulted in skyrocketing control premiums, exemplifying the inverse relationship.
In the period from 2004 through 2007 (before the financial crisis), the DJIA increased from 10,315 to 13,178 (or approximately 28 percent), while the median control premium was roughly 25.4 percent.
During the financial crisis, the DJIA bottomed at 6,469.95 in March of 2009. Around this period, control premium medians rose to 38.6 percent, 44.8 percent, and 54.0 percent, in 2008, 2009, and 2010, respectively. However, as the stock market recovered in 2011, control premiums began to revert down to their typical range of 20 to 30 percent by 2013, where they remained through 2019. During the same period from 2011 to 2019, the DJIA average increased by 120 percent, while control premiums dropped by approximately 17 percent.
Data would suggest that we can expect a rise in the premium buyers are willing to pay for control.
In today’s market environment, with the news dominated by fears around the unknown potential damage arising from the novel coronavirus, most indices remain 20 to 25 percent off of their highs. Data would suggest that over the past five years, as equities rallied and control premium medians fell to approximately 25 percent from over 30 percent, that we can expect a rise in the premium buyers are willing to pay for control.
Based on empirical data, the timeliness of this effect on control premiums remains to be seen. It is still too early in this market cycle for existing deals to have been impacted. An adjustment could be immediate, but it may take multiple quarters for prices to correct. It can be expected that median control premiums will rise above 30 percent once again if the appetite for deals justifies the prices market participants are willing to pay.