Fair Value in Arm's-Length Third-Party Transactions
With the rise of appraisal arbitrage, an increasing number of appraisal petitions and an increase in the size of appraisal classes, corporate practitioners have closely followed recent appraisal decisions in the Delaware Court of Chancery. In cases involving third-party arm's-length transactions and robust bidding, several more recent decisions established a level of predictability to the valuation analysis, looking to the negotiated merger price as the best evidence of the fair value that appraisal claimants are entitled to receive. In those cases the court rejected expert valuations of higher or lower amounts based on discounted cash flow and other expert financial analyses. The Court of Chancery's recent decision in In re Appraisal of DFC Global, C.A. No. 10107-CB (July 8), will likely create new uncertainty about the reliability of the market to establish fair value in an appraisal.
In DFC Global the court found the transaction price was not the best evidence of fair value notwithstanding a robust two-year sale process. It ruled that the "merger price is reliable only when the market conditions leading to the transaction are conducive to achieving a fair price." Finding that the transaction was negotiated during a period of significant company turmoil and regulatory uncertainty, the court questioned the reliability of the transaction price and management's financial projections. Giving equal weight to three "imperfect" techniques—the court's own modification of the competing DCF analyses ($13.07/share), a comparable companies multiple analysis ($8.07/share), and the merger price ($9.50/share)—the court concluded that Global's fair value for appraisal purposes was $10.21/share.
Global's business is payday lending. It was publicly traded on NASDAQ from 2005 until Lone Star acquired it in a merger in June 2014. Global operated in 10 countries through more than 1,500 retail operations and internet platforms, and faced significant competition in each country. Global and its business faced regulation from different authorities across its market. Assessing the regulatory risk proved difficult. On the one hand, the company had a good track record for navigating regulatory change over its years of operation, and it hoped it could increase its market share as its competitors faced difficulties operating within the stricter regulatory environment. On the other hand, during the January-April 2014 period leading up to Global's sale, it twice cut its earnings guidance for 2014 from $200 to $240 million EBITDA to $151 to $156 million, noting the increasingly difficult regulatory environment for payday lenders. In late 2013, before the earnings revisions, Global had received preliminary nonbinding indications of interest from Lone Star at $12.16/share and $13.50 from another bidder. Lone Star admittedly sought to take advantage of the uncertainty by buying Global at a time when its performance was weak and its outlook unclear. Lone Star initially offered to buy Global on Feb. 28, 2014, at $11/share. Subsequently, it reduced its offer to the eventual transaction price of $9.50/share in late March following a downward earnings revision by Global's management.
Both the petitioner and the respondent company employed reputable experts from well-regarded firms. The petitioner relied solely on a DCF analysis, which produced a value of $17.90/share. The respondent relied on a DCF analysis of $7.81/share and a comparable companies analysis of $8.07/share, weighted equally for a fair value of $7.94/share. The respondent also argued that the transaction price of $9.50/share was a reliable indicator of value. The court expressed a now familiar lament about the great disparity between the experts DCF valuations before proceeding to resolve the many disagreements about the DCF inputs and reaching its own DCF valuation of $13.07 per share.
Although Delaware courts frequently rely upon the DCF methodology to value companies, often to the exclusion of other methods, this case illustrates just how subjective are many of the DCF inputs and how sensitive the resulting valuations are to such inputs. Here, even though the experts agreed on several factors and used management's March 2014 projections, the experts disagreed about many of the factors used to calculate Global's weighted cost of capital—beta, the method of unlevering and relevering beta, the appropriate size premium and tax rate—as well as other inputs including adjustments to the company's projected cash flows, adjustments to expenses to account for stock-based compensation and whether to use a two-stage or three-stage DCF model. These differences led to widely divergent values.
The court did an admirable job of analyzing appraisal precedent, the competing expert views and the supporting financial literature before eventually deriving a DCF value slightly higher than the midpoint of the competing expert valuations. Noting the DCF analysis "may deserve significant emphasis or sole reliance in cases where the court has more confidence in the reliability of the underlying projections than in the transaction price," the court found that the uncertainty inherent in management's projections existed also in the sales process. Finding that the sales process extended over a significant period of time and appeared to be robust, the court nevertheless concluded that the transaction price was not necessarily a reliable indicator of Global's intrinsic value.
The real difficulty posed by Global lies in the court's use of a highly sensitive DCF analysis yielding a value approximately 40 percent higher than either of the market-based analyses. The court muted the effect by averaging the DCF result with the transaction price and values derived from comparable company transactions. But one is left to wonder why or how use of the widely divergent DCF analyses in the court's valuation determination improves upon the market-based analyses or accounts for the court's concern with the impact of regulatory uncertainty. Implicitly, the court concluded that the risk caused by the regulatory uncertainty depressed Global's market value below its fair value and that use of an admittedly imperfect DCF analysis was necessary to capture the company's fair value. Although other judges have looked to the transaction price as the best indicator of fair value in the absence of reliable DCF analyses, the Global decision reminds practitioners of the ongoing importance of the DCF methodology to the court's valuation task.