<<

. 9
( 18)



>>

premiums paid for ¬nancial buys. This leads to the conclusion that ac-
quisition premiums are control premiums, not premiums for synergy.
This conclusion supports Mercer (1990) and Bolotsky in their opinion
that the similarity of premiums for acquiring minority positions and con-
trol positions can be explained as acquiring ˜˜creeping control,™™ because
it appears to rule out synergy as an explanation. This is in contrast to
Nath™s position and Mercer (1998 and 1999).

Mercer (1998) and (1999)
Mercer (1998) represents a signi¬cant change in thinking since his 1990
article. He now believes that the majority of premiums for mergers and

T A B L E 7-2

Acquisition Premiums by SIC Code


SIC Code Differences Between Buyer & Seller 5-Day Avg Prem

0 37.2%
1“9 41.0%
10“48 37.1%
50+ 50.8%

Source: George P. Roach, ˜˜Control Premiums and Strategic Mergers,™™ Business Valuation Review (June 1998), Table IV, p. 47.




PART 3 Adjusting for Control and Marketability
206
acquisitions recorded in Houlihan Lokey Howard & Zukin™s Mergerstat
represent strategic premiums for synergies, which do not qualify for fair
market value. He has modi¬ed the traditional levels of value chart in the
top of Figure 7-1 to the one in the middle. It is the same as the one above,
with the addition of a strategic value above the control value.
For sake of discussion, let™s look at an end-of-year Gordon model
formula to calculate value.

CFt 1(1 b)
PV(Cash Flows)
r g

where r is the discount rate, g is the constant growth rate, and b is the
retention ratio for the company, i.e., it retains b (with 0 b 1), leaving
(1 b) times the next year™s forecast cash ¬‚ow as forecast dividends.
Mercer™s position (Mercer 1999) is that the discount rate is the same
at the marketable minority level as it is in all levels of value above that
(though not the same as the private minority level, which almost always
carries a higher discount rate). The main difference in the valuation comes
from the numerator, not the denominator. Control buyers, whether ¬nan-
cial or strategic, upwardly adjust forecast cash ¬‚ows. He details the types
of adjustments as follows:
1. Normalizing adjustments: these adjust private company earnings
to well-run public company equivalent. Mercer classi¬es two
types of normalizing adjustments. Type 1 is to eliminate
nonrecurring items and adjust for non-operating assets. Type 2
is to adjust insider compensation to an arm™s length level,
including eliminating discretionary expenses that would not
exist in a public company.
2. Control adjustments: Mercer lists two types of control
adjustments. Type 1 are for what Jankowske calls performance
improvements and apply to both ¬nancial buyers and strategic
buyers. Mercer says these are adjustments for improving the
(existing) earnings stream, i.e., running the company more
ef¬ciently. This could also include the volume discounts coming
from the buying ef¬ciencies achievable by being owned by a
larger company that is a ¬nancial buyer. Type 2 are for changing
the earnings stream, i.e., running the company differently, and
apply only to strategic buyers. These include consolidating G&A
expenses, eliminating duplicate operations, selling more product,
and negotiating power with suppliers, distributors, or customers
that is above and beyond that which can be achieved by a
¬nancial buyer.
Mercer is in very good company in this position. Consider (Pratt
1998, p. 134): ˜˜The exploitation of minority shareholders is far less prev-
alent in public companies than in private companies, at least in larger
public companies. If company cash ¬‚ows are already maximized and the
returns are already distributed pro rata to all shareholders, then there
may be no difference between a control value and a minority value.™™




CHAPTER 7 Adjusting for Levels of Control and Marketability 207
Other similar opinions can be found in Ibbotson (1999), Zukin (1998), and
Vander Linden (1998).
Actually, Mercer is not the originator of this position on control pre-
miums, but he may be the person who has written the most about it. The
original statement of this position came from Glass and McCarter (1995).

Summary of Professional Research on Control Premiums
Now we will summarize the past 10 years of professional research on
control premiums. The primary research supporting the traditional con-
trol premiums of 35% to 40 % is Roach™s. The other extreme”a zero
control premium”is represented by Nath and Mercer. While the original
gap between Nath™s and Mercer™s positions on control premiums was
large, the current gap is much smaller and often may not even exist. The
logic of how they arrived at their opinions is different, but they would
probably come to similar calculations of control premiums in the majority
of circumstances.
Nath does not ever use control premiums. Mercer, following Glass
and McCarter, now agrees that after taking into consideration increases
in forecast cash ¬‚ows from performance improvements and arm™s length
salary adjustments for the control shareholder that are appropriate for a
¬nancial buyer, there are no control premiums. In the absence of infor-
mation to do so, he says control premiums should be very small”no
more than 10%, with the implication that it could still be as little as zero.
That is essentially Nath™s position, that the public minority value is a
control value and therefore we should not apply control premiums to a
discounted cash ¬‚ow valuation. Mercer rarely assigns control premiums
unless there are identi¬able increases in forecast cash ¬‚ows at the control
level. In that case, he would simply increase the cash ¬‚ow forecast and
the control level value would increase vis-a-vis the marketable minority
`
interest level. Nath would do the same thing, except he does not like the
term marketable minority level of value (or its synonym, as if freely traded).
Their terminology differs far more than their results, at least with regard
to control premiums.
Regarding the discount for lack of marketability (DLOM), neither
Mercer nor Nath believes in taking DLOM for a control interest”a po-
sition with which I disagree in the DLOM section of this chapter. Nath™s
reason for this position is that the M&A and business brokerage markets
are very active, and that activity negates any tendency to a DLOM. He
makes an analogy of the real estate market to the market for companies.
Rather than apply DLOM, real estate appraisers put an ˜˜expected mar-
keting time™™ on their values. Mercer™s main reason for opposing DLOM
for control interests is that they control cash ¬‚ows until a sale.
Nath always begins with a controlling owner™s value, which in his
view is the greater of the values obtained by the M&A markets, the public
markets (reduced by the restricted stock discount that one would expe-
rience in going public), and liquidation. It is extremely important to note
that to the extent that the M&A market values contains synergies and
whenever the M&A valuation dominates, Nath™s fair market values will
contain synergies.
His opinion is that that is what buyers will pay, and therefore that
is fair market value. There is a question as to whether that is investment

PART 3 Adjusting for Control and Marketability
208
value rather than fair market value. I agree that it probably is not in-
vestment value, as it is not value to a particular buyer. It is value to an
entire class of buyers. If all buyers in the M&A market are strategic”
which is certainly not completely true, but may be largely true is some
industries”then that is what buyers would pay. With this ¬ne distinction,
it is very important to make sure that if one follows Nath™s method, one
must be careful that the subject company ¬ts with the assumptions un-
derlying Nath™s logic.
I do not believe that most small ¬rms and many midsized ¬rms are
serious candidates for the M&A market. They are business broker mate-
rial, and such buyers would rarely ever be synergistic. Therefore, it is
imperative to be realistic about the market in which the subject company
is likely to sell.
For a private minority interest, Nath takes both the discount for lack
of marketability and lack of control. In conversation, he has revealed his
own dissatisfaction with the lack of relevant information for calculating
DLOC, since there is still nothing to use other than the traditional ¬‚ip
side of the control premiums that he personally demolished as being valid
premiums to add to a ˜˜minority value.™™
Mercer comes to what probably amounts to a very similar result
through a different path. He does not calculate a discount for lack of
control for private minority interests. Instead, he uses his quantitative
marketability discount model (QMDM) (which we cover in more detail
later in this chapter) to subsume any DLOC, which he feels is automati-
cally included in his DLOM. I agree with Mercer that the QMDM includes
the impact of DLOC because, in the QMDM, one must forecast the spe-
ci¬c cash ¬‚ows to the minority shareholder and discount them to present
value. Thus, by using the QMDM, Mercer does not need a DLOC. Mer-
cer™s position is internally consistent.


Prior Research”Academic
Now that we have summarized the professional literature, we will sum-
marize the results of various academic studies relevant to our topic. The
primary orientation of academic research in ¬nance is on publicly traded
stocks. It is generally not directly concerned with the issues of the valu-
ation profession, which is focused on valuing private ¬rms. Often a
slightly interesting side point in an academic article is a golden nugget
for the valuation profession”if not a diamond.
There are two types of evidence of the value of control. The ¬rst is
the value of complete control. The second deals with the value of voting
rights. Voting rights do not represent control, but they do represent some
degree of in¬‚uence or partial control.11
The academic research falls into the following categories:
1. The article by Schwert focuses primarily on analyzing returns in
mergers and acquisitions during two periods: the runup period,


11. Mergerstat Review does track premiums for acquisitions of minority interests, which make up a
third category of evidence. I am not aware of any academic literature dealing with this
issue.


CHAPTER 7 Adjusting for Levels of Control and Marketability 209
which is the time before announcement of the merger, and the
markup period, which is the time period after the
announcement. This is signi¬cant in the context of this book
primarily as providing empirical evidence that is relevant in my
economic components model for the discount for lack of
marketability (DLOM). It could easily belong to the DLOM part
of this chapter, but I include it here with the rest of the
academic articles.
2. The articles by Lease, McConnell, and Mikkelson; Megginson;
Houlihan Lokey Howard & Zukin (HLHZ); and the section on
international voting rights premia all deal with the value of
voting rights and provide insight on the value of control that
¬ts in the de¬nition of fair market value.12
3. The articles by Bradley, Desai, Kim and Maquieira, Megginson,
and Nail are about the value of complete control. In particular,
their focus is on measuring the synergies in acquisitions, which
is a critical piece of evidence to understand in sorting through
the apparently con¬‚icting results and opinions in the
professional literature.
4. The article by Menyah and Paudyal is an analysis of bid“ask
spreads and is primarily related to DLOM, not control. It could
also have been included in section on marketability.

Schwert (1996)
Since business appraisers calculate control premiums and discounts for
lack of control from merger and acquisition (M&A) data of publicly
traded ¬rms, it is important to understand what variables drive control
premiums in order to be able to properly apply them to privately held
¬rms. Schwert™s article has some important ¬ndings.
Schwert™s main purpose is to examine the relationship between run-
ups and markups in M&A pricing. (The runup period is that period of
time before the announcement of a merger in which the target ¬rm™s price
is increasing.) Schwert ¬nds that cumulative abnormal returns (CARs)13
begin rising around 42 days before an acquisition. Thus, he de¬nes the
runup period from day 42 to day 1, with day 0 being the announce-
ment of the merger. The markup period is from day 1 to day 126 or
delisting, whichever is ¬rst. The sum of the runup and markup period is
the entire relevant timeline of an acquisition, and the sum of their CARs
is the total acquisition premium.
Schwert ¬nds that CARs during the runup period for successful ac-
quisitions between 1975“1991 average 25%, with CARs for unsuccessful
acquisitions, i.e., where the bidder ultimately fails to take over the target,
averaging 19%.14 After the announcement date, CARs for successful ac-


12. The HLHZ article is professional rather than academic, but its topic ¬ts in better in our
discussion of academic research.
13. These are the cumulative error terms for actual returns minus market returns calculated by
CAPM.
14. One thousand, eight hundred and fourteen transactions in total, which are later reduced to
1,523 in his main sample.


PART 3 Adjusting for Control and Marketability
210
quisitions increase to 37%, while for unsuccessful acquisitions they de-
crease to zero.
He discusses two opposite bidding strategies, the substitution hy-
pothesis and the markup pricing hypothesis.
The substitution hypothesis states that each dollar of preannounce-
ment runup reduces the post-bid markup dollar for dollar. The assump-
tions behind this hypothesis are that both the bidder and the target have
private information that is not re¬‚ected in the market price of the stock
and that no other bidder has valuable private information. Therefore,
both the bidder and the target will ignore price movements that occur
prior to and during the negotiations in setting the ¬nal deal price.
The markup pricing hypothesis is that each dollar of preannounce-
ment runup has no impact on the post-bid markup. Thus, the prean-
nouncement runup increases the ultimate acquisition premium dollar for
dollar. The assumption behind this hypothesis is that both the bidder and
the target are uncertain about whether movements in the market price of
the target™s shares re¬‚ect valuable private information of other traders.
Therefore, runups in the stock price could cause both the bidder and the
target to revise their valuations of the target™s stock. Schwert used the
example that if they suspect that another bidder may be acquiring shares,
both the bidder and the target will probably revise their valuations of the
target™s stock upward.
The markup hypothesis re¬‚ects rational behavior of bidders and tar-
gets when they have incomplete information. A different explanation of
the markup hypothesis is that of Roll (1986), who postulates that bidders
are interested in taking over targets regardless of cost (the hubris hy-
pothesis). This would re¬‚ect irrational behavior. Using regression analy-
sis, Schwert ¬nds strongly in favor of the markup hypothesis, while re-
jecting Roll™s hubris explanation as well as the substitution hypothesis.
Had the substitution hypothesis been the winner, this would have
implied that the acquisition premiums that occur in the market would
require major adjustments for calculating fair market value. It would have
meant that the post-bid markups are based on private information to a
particular buyer and seller, who ignore the effects of the pre-bid runup
because they both believe that no other bidder has valuable private in-
formation. This would then be investment value, not fair market value.
With the markup hypothesis being the winner, at least we do not have
that complication.
For professional appraisers, the most important ¬nding in Schwert™s
paper is the impact of competitive bidding, i.e., when there is more than
one bidder for a target, on the cumulative abnormal returns on the tar-
get™s stock. Approximately 20% of the takeovers were competitive (312
out of 1,523), with 80% (1,211 out of 1,523) noncompetitive. Table 4 in the
article shows that the presence of competitive bidding increases the pre-
mium paid by 12.2%.15 This is signi¬cant evidence of the impact of com-
petition that will have an important role to play in calculating D2, the



15. That is, it adds an absolute 12.2% to the premium. It does not increase the premium by 12.2%.
For example, if the average premium with only one bidder is 30%, with two or more
bidders it is 42.2%.


CHAPTER 7 Adjusting for Levels of Control and Marketability 211
component in Abrams™ economic components model of the discount for
lack of marketability due to the absence of competition in thin markets.
We will cover that in detail later in this chapter.

Lease, McConnell, and Mikkelson (1983)
Lease, McConnell, and Mikkelson (LMM) examined all companies with
two classes of common stock outstanding sometime between 1940 and
1978. Both classes of common shares were entitled to identical dividends
and liquidation preferences. In total, 30 companies met the criteria, al-
though never more than 11 companies in any one year. On average, there
were only 7 companies in the population per year.
LMM found a statistically signi¬cant voting rights premium. They
split their population into three categories. Category 1 ¬rms had only
voting and nonvoting common, with no voting preferred stock. Category
2 ¬rms had two classes of voting common”one with superior voting
rights and one with inferior voting rights. Category 3 ¬rms had superior
voting common, either nonvoting or inferior voting common, and voting
preferred. Their results were as follows:


Category Mean Voting Rights Premium

1 3.8%
2 7.0%
3 1.1%




The mean voting premium of the Category 1 and 2 ¬rms is 5.44%.
There is no logical reason why Category 2 ¬rms should have a higher
voting rights premium than Category 1 ¬rms, and the authors labeled
this result ˜˜a puzzle.™™ The relationship should have been the opposite.
There was one large outlier in Category 2. Without it, the Category 2
premium is only 1.9%. However, the authors investigated this outlier
thoroughly and found no reason to exclude it from the data. It had no
distinguishing characteristics.
As to the other puzzling result of a voting rights discount to the
superior common shares in the presence of voting preferred stock, the
authors speculate that there might be some incremental costs borne by
the superior rights shares that are not borne by the inferior rights shares.
However, Megginson (1990) and the HLHZ articles did not ¬nd this re-
sult. Megginson found a 23% premium for Category 3.

Megginson (1990)
The author analyzes 152 British ¬rms traded on the London Stock
Exchange in the 28 years from 1955“1982 that have at least two classes
of common stock, with one class possessing superior voting (SV) power
to the other, for the purpose of explaining the underlying variables that
explain the voting rights premium (VRP) to the SV shares. He labels the
inferior common shares those with restricted voting (RV) power. While
the article does not say so, in one of many telephone conversations that
I had with Professor Megginson, he said that all of the RV shares are
simply nonvoting, even though he was using a more generic terminology.

PART 3 Adjusting for Control and Marketability
212
A minority of ¬rms in his sample also had preferred shares. His work is
a continuation of that of Lease, McConnell, and Mikkelson in a different
environment.
Megginson was hoping for his regression analysis to shed light on
which of three competing hypotheses explain the voting rights premium
to SV shares. Ultimately, the regression results could not shed any light
on the source of VRP. However, his article does provide some information
to determine the magnitude of the control premium that is purely for
control and not for anticipated higher cash ¬‚ows.
Under the ownership structure hypothesis, there is an optimal
amount of stock ownership for insiders”management and directors. If
insiders hold too little SV stock, company performance can be improved
by increasing insider ownership. However, if insiders own too much SV
stock, they can become overly entrenched and immune to forced removal,
lowering the value of all classes of stock in general and restricted voting
(RV) stock in particular.
Under this hypothesis, the voting rights premium is positively re-
lated to insider holdings of SV shares and negatively related to RV shares.
The reason for the former is the entrenchment effect, and the reason for
the latter is that the larger the percentage of RV shares owned by insiders,
the more incentive they have to maximize the value of RV shares.
Some of the more interesting summary statistics from Megginson are
listed below. Pay particular attention to numbers 3 and 4”as they contain
the main information for our analysis below.
1. SV shares represented 38.4% of total common equity but 94.3%
of total voting power.
2. Insiders held 28.7% of SV shares (29.8% for companies with
voting preferred) and 8.6% of RV shares (2.7% for companies
with voting preferred).
3. The mean voting rights premium was 13.3% across all ¬rms,
23% for ¬rms with voting preferred, and 6% for ¬rms that were
subsidiaries of other companies.
4. Forty-three of the 152 ¬rms (28.3%) were taken over during the
sample period. In 37 out of the 43 cases, which is 86% of the 43
¬rms or 24.3% percent of the entire sample of 152 ¬rms, the SV
shares received higher prices than the RV shares by an average
27.6%.16 The existence of signi¬cant tender offer premiums that
go disproportionately to SV shares and whose timing is
generally unknown could possibly explain the VRP, though
Megginson feels the magnitudes of the VRP are too high to be
explained by 28% premiums at unknown times.
5. His regression analysis in logarithmic form17 with the ratio of
the price of SV shares to the RV shares as the dependent
variable found the percentage holdings of insiders of SV and RV



16. It is unclear whether the 27.6% refers to all 43 ¬rms or just the 37 ¬rms where the SV shares
received a premium over the RV shares. Assuming the former instead of the latter changes
the conclusion later in the chapter in Table 7-3, cell D24 from 1.4% to 1.5%.
17. The logarithm of the price variables most closely approximates a normal distribution.


CHAPTER 7 Adjusting for Levels of Control and Marketability 213
shares as the only statistically signi¬cant variables. The former
was positively related and the latter negatively related to the
ratio of prices. Even then, the adjusted R2 was only 11%.

My Conclusions from the Megginson Results. The British VRP of
13.3% is signi¬cantly higher than the American VRP, which in the Lease,
McConnell, and Mikkelson study is 5.4% and in the Houlihan Lokey
Howard & Zukin study (which follows the section on Megginson) is 3.2%.
The purpose of this section is to determine how much of the 13.3% VRP
is for the power of the vote versus the higher expected cash ¬‚ows to the
SV shareholders.
The analysis that follows shows that of the 13.3% VRP, 11.9% is due
to higher expected cash ¬‚ows to the SV shareholders and 1.4% is being
paid purely for the right to vote.
The rest of this section is a detailed explanation of Table 7-3, which
is my quantitative analysis of the Megginson results. The reader who
wants to save time can safely skip the rest of this section and continue
with the Houlihan Lokey Howard & Zukin (Much and Fagan) study.

My Analysis of the Megginson Results. We assume that the average
holding period on the London Stock Exchange during the 1955“1982 pe-
riod was ¬ve years. The table begins with expected cash ¬‚ows to the
shareholders in rows 6 to 13, which we show in two different scenarios.
In scenario #1 (Columns A“F), the ¬rm will not be acquired during the
shareholder™s tenure. In scenario #2 (Columns H“M), the ¬rm will be
acquired during the shareholder™s tenure.
The assumptions of the model are as follows:
1. Using large capitalization NYSE ¬rm data from the SBBI
yearbooks,18 for the years 1955“1982, total returns were 10.48%
(B30), which we use as our discount rate. This broke down to a
dividend yield of 3.94% (B27) and capital gains return of 6.54%
(B29).
2. The voting rights premium is 13.3% (B28), per Megginson
(1990).
3. When ¬rms were acquired, we assume a 20% acquisition
premium to the RV shares.19 The ¬nal results are insensitive to
the magnitude of this assumption.
4. The SV shares receive a premium that is 27.6% (B32) higher than
the RV shares in the event of an acquisition.
The RV shareholder cash ¬‚ows appear in cells C6 to C12. The share-
holder invests $1.00 (C6) at time zero. In Year 1, he or she receives divi-
dends of 3.94% $1.00 $0.0394 (C7). As the shares rise in price by
6.54% (B29) annually, applying the constant dividend yield is equivalent


18. London Stock Exchange data were unavailable to us. We use NYSE data as a proxy for the LSE
data. According to Professor Megginson, the NYSE data should be a good proxy for the
LSE.
19. These data did not appear in the article and are no longer available.




PART 3 Adjusting for Control and Marketability
214
T A B L E 7-3

Analysis of Megginson Results


A B C D E F H I J K L M

4 Scenario #1: SV Shares-No Acquisition Scenario #2: SV Shares-Acquisition

5 Yr SV RV PV Factor [1] NPV SV NPV RV Yr SV RV PV Factor [1] NPV SV NPV RV
6 0 1.1330 1.0000 1.0000 1.1330 1.0000 0 1.1330 1.0000 1.0000 1.1330 1.0000
7 1 0.0394 0.0394 0.9051 0.0357 0.0357 1 0.0394 0.0394 0.9051 0.0357 0.0357
8 2 0.0420 0.0420 0.8193 0.0344 0.0344 2 0.0394 0.0394 0.8193 0.0323 0.0323
9 3 0.0447 0.0447 0.7416 0.0332 0.0332 3 0.0394 0.0394 0.7416 0.0292 0.0292
10 4 0.0476 0.0476 0.6712 0.0320 0.0320 4 0.0394 0.0394 0.6712 0.0264 0.0264
11 5 0.0508 0.0508 0.6075 0.0308 0.0308 5 0.0394 0.0394 0.6075 0.0239 0.0239
12 5 1.5552 1.3727 0.6075 0.9449 0.8340 5 2.101819 1.647194 0.6075 1.2770 1.0008
13 Total 0.0221 0.0000 Total 0.2915 0.1483


15 Summary of NPVs SENSITIVITY ANALYSIS: NPV of RV-SV

16 No Acq Acquisition Total
17 SV 0.0221 0.2915 Capital RV-SV
18 RV 0.0000 0.1483 Apprec
19 Probabilities [2] 94.95% 5.05% 100.00% 0.00% 0.0461
20 Probability Wtd NPVs 2.00% 0.0371
21 SV 0.0210 0.0147 0.0062 4.00% 0.0273
22 RV 0.0000 0.0075 0.0075 6.54% 0.0137
23 RV-SV 0.0137 8.00% 0.0053
24 RV-SV (in percent) 1.4% 10.48% 0.0100
26 Assumptions
27 Dividend yield [3] 3.94%
28 Voting rights prem 0.133
29 Cap apprec g [3] 6.54%
30 Disc rate r [3] 10.48%
31 Acq prem-RV [4] 20%
32 SV/RV acq prem 27.6%

[1] Present value factors are end-of-year. Using midyear factors makes no difference in the ¬nal result to four decimal places.
[2] Probability of acquisition 5 year holding period/[152 Firms/(43 Acquisitions/28 Years)], or 5 Years / 98.98 years
[3] Derived from SBBI-1999 for 1955-1982. We use the US data as a proxy for UK data, as the latter were unavailable.
[4] This is an assumption, as the data were unavailable. However, the ¬nal results are insensitive to the assumption.
215
to having dividends rise by the same capital appreciation percentage of
6.54%. Thus, $0.0394 (1 0.0654) $0.0420 (C8). As we go down
the column, each year™s dividend is 6.54% higher than the previous
year™s. The ¬nal dividend is $0.0508 (C11). Finally, at the end of Year
5, the shareholder sells for $1.3727 (C12), which is the original invest-
ment of $1.00, with ¬ve years of compound growth at the 6.54% or
1.06545
$1.00 $1.3727.
The SV share cash ¬‚ows begin with a $1.133 investment (B6). The SV
shareholders receive the same dividend stream as the RV shareholders,
so B7 through B11 is the same as those rows in column C. At the end of
Year 5, the SV shareholder sells at the voting rights premium of 13.3%,
i.e., $1.3727 1.133 $1.5552 [C12 (1 B28) B12].
We discount the forecast cash ¬‚ows at the average return of 10.48%
(B30). The end-of-year present value factors at 10.48% appear in D6 to
D12. Multiplying the SV and RV forecast cash ¬‚ows by the present value
factors leads to present values of the SV and RV forecast cash ¬‚ows in
E6 through E12 and F6 through F12, respectively. The totals are the net
present values of the investments, which are $.0221 (E13) and 0 (F13)
for SV and RV.
The analysis of scenario #2 is structured identically to that of scenario
#1. The forecast cash ¬‚ows in I6 through J11, which are the initial in-
vestments and the dividends, are identical to their counterparts in col-
umns B and C. The only differences are in Year 5, where we assume
the ¬rms are acquired. The acquisition amount for the RV shares is com-
posed of two parts. The ¬rst is the ¬ve years of growth at 6.54% (B29), or
1.06545 $1.3727, which is the same as C12. We then multiply that by 1
plus the assumed acquisition premium for RV shares of 20% (B31), or
$1.3727 1.2 $1.647194 (J12). The actual premium is unknown; how-
ever, a sensitivity analysis showed our ¬nal results are insensitive to this
assumption within a fairly wide range around our assumption.
The SV buyout occurs at the SV-over-RV premium of 27.6% (B32), or
$1.647194 1.276 $2.101819 (I12). The present values of the cash ¬‚ows
are $0.2915 (L13) and $0.1483 (M13) for SV and RV shares when there is
an acquisition.20
We now proceed to the summary of the net present values (NPVs)
and begin with the no-acquisition scenario. In B17 and B18, we transfer
the NPVs of $0.0221 and zero from E13 and F13 for the SV and RV
shares. We then multiply those conditional FMVs by the probability of
not being acquired in our assumed ¬ve-year holding period, which is
94.95% (B19) and is calculated in footnote [2] to Table 7-3. The probability-
weighted NPVs for the SV and RV shares are $0.0210 and 0 (B21, B22).
Next we transfer the acquisition scenario NPVs of $0.2915 and
$0.1483 for SV and RV shares from L13 and M13 to C17 and C18, re-
spectively. We multiply those NPVs by the probability of acquisition of
5.05% (C19), which is 1 minus the 94.95% in B19, to obtain the probability-



20. Actually, the present values are slightly higher, as the acquisitions could take place before Year
5. However, this simpli¬cation has no material impact on the outcome of the analysis.




PART 3 Adjusting for Control and Marketability
216
weighted NPVs of $0.0147 (C21) and $0.0075 (C22) for the SV and RV
shares.
We add columns B and C to obtain the probability-weighted NPVs
of SV shares of $0.0062 (D21) and $0.0075 (D22). The RV minus SV NPV
difference is $0.0137 (D23), or approximately 1.4% (D24) of the RV share
price.
Let™s do a recap of this table, as it is very detailed. At the 10.48%
(B30) discount rate, the RV shares are priced exactly right, assuming there
will be no acquisition, i.e., they have a zero present value (F13), while
they actually have a small, positive weighted average NPV of $0.0075
(D22) after including the 5% probability of an acquisition premium. Thus,
RV shares are a good buy based on expected cash ¬‚ows for one with a
10.48% hurdle rate.
The SV shares, on the other hand, are a bad buy on a pure discounted
cash ¬‚ow basis. In the absence of an acquisition, which is a 95% proba-
bility for a ¬ve-year holding period, the NPV is $0.0221 (E13, trans-
ferred to B17). The positive NPV of $0.2915 (L13, transferred to C17) in
the event of an acquisition, which is only a 5% probability, is insuf¬cient
to outweigh the negative NPV absent the acquisition. Overall, the SV
shares have a negative NPV of $0.0062 (D21). On a pure basis of NPV
of forecast cash ¬‚ows, the RV shares have a $0.0137 (D23) NPV differential
over the SV shares. The investor in SV shares passed up $0.014 (rounded)
of NPV to buy the vote, or 1.4% (D24) of the $1.00 RV price. We subtract
this from the average SV price of $1.133, and $1.119, or 11.9% of the 13.3%
voting rights premium is justi¬ed by higher expected cash ¬‚ows, while
1.4% of it appears to be paid for the right to vote and the marginal power
that goes with it.
In the middle-right section of the table, we present a sensitivity anal-
ysis of the SV-RV NPV differential. The SV-RV NPV differential rises as
the fraction of the total return shifts more towards dividend yield and
away from capital appreciation. For example, if capital appreciation ac-
counted for none of the 10.48% yield, then the portion of the $0.133 voting
rights premium attributable to the power of the vote rises to $0.0461 (I19)
versus the base case.
The intuition for this result is that when returns are weighted more
heavily towards dividends, the SV shares receive a lower effective divi-
dend yield. This is because the SV shares receive the same absolute div-
idends as the RV shares but paid a higher price per share to receive them.
Also, both SV and RV share prices grow more slowly, and the absolute
cash value of the 27.6% SV-over-RV premium upon acquisition is less than
when returns are primarily in the form of capital gains.
Table 7-3A is identical to Table 7-3, but it is for the Lease, McConnell,
and Mikkelson study. The net VRP is 1.1% (D24).

The Houlihan Lokey Howard & Zukin (HLHZ) Study
Much and Fagan (2000), of HLHZ, describe their own update of the Lease,
McConnell, and Mikkelson study. The HLHZ study consists of 18 dual-
class ¬rms with identical dividend rights and liquidity preference. While
this is professional rather than academic research, we include it here be-
cause it is an update of academic research and ¬ts in better topically.



CHAPTER 7 Adjusting for Levels of Control and Marketability 217
218
T A B L E 7-3A

Analysis of American VRP Results


A B C D E F H I J K L M

4 Scenario #1: SV Shares-No Acquisition Scenario #2: SV Shares-Acquisition

5 Yr SV RV PV Factor [1] PV SV NPV RV Yr SV RV PV Factor [1] PV SV NPV RV
6 0 1.0544 1.0000 1.0000 1.0544 1.0000 0 1.0544 1.0000 1.0000 1.0544 1.0000
7 1 0.0394 0.0394 0.9051 0.0357 0.0357 1 0.0394 0.0394 0.9051 0.0357 0.0357
8 2 0.0420 0.0420 0.8193 0.0344 0.0344 2 0.0394 0.0394 0.8193 0.0323 0.0323
9 3 0.0447 0.0447 0.7416 0.0332 0.0332 3 0.0394 0.0394 0.7416 0.0292 0.0292
10 4 0.0476 0.0476 0.6712 0.0320 0.0320 4 0.0394 0.0394 0.6712 0.0264 0.0264
11 5 0.0508 0.0508 0.6075 0.0308 0.0308 5 0.0394 0.0394 0.6075 0.0239 0.0239
12 5 1.4473 1.3727 0.6075 0.8793 0.8340 5 1.921726 1.921726 0.6075 1.1675 1.1675
13 Total 0.0090 0.0000 Total 0.2607 0.3151
15 Summary of NPVs SENSITIVITY ANALYSIS: NPV of RV-SV

16 No Acq Acquisition Total Discount RV-SV
17 SV 0.0090 0.2607 Rate
18 RV 0.0000 0.3151 8% 0.0061
19 Probabilities [2] 94.95% 5.05% 100.00% 10.48% 0.0113
20 Probability Wtd NPVs 12% 0.0142
21 SV 0.0086 0.0132 0.0046 14% 0.0176
22 RV 0.0000 0.0159 0.0159
23 RV-SV 00.0113 Capital RV-SV
24 RV-SV (in percent) 1.1% Apprec
25 0.00% 0.0230
26 Assumptions 2.00% 0.0230
27 Dividend yield [3] 3.94% 4.00% 0.0162
28 Voting rights prem [5] 0.0544 6.54% 0.0113
29 Cap apprec g [3] 6.54% 8.00% 0.0083
30 Disc rate r [3] 10.48% 10.48% 0.0027
31 Acq perm-both [4] 40%
32 SV/RV acq prem 0.0%

[1] Present value factors are end-of-year. Using midyear factors makes no difference in the ¬nal result to four decimal places.
[2] Probability of acquisition is from the British data. However, increasing cell C19 to 25% causes D24 to rise to only 2%.
[3] Derived from SBBI-1999 for 1955-1982.
[4] This is an assumption, as the data were unavailable. However, the ¬nal results are insensitive to the assumption.
The HLHZ study presents the VRP over a very short period of time
ending with December 31, 1994.21 In this respect it is very different than
the two previous studies, which present VRP averages over many years.
The Lease, McConnell, and Mikkelson VRP results are the averages over
38 years, while the Megginson results are averages over 28 years. In con-
trast, the HLHZ study covers a short snippet of time.
The 260-day moving average mean and median voting rights pre-
miums were 3.2% and 2.7%, respectively, while they were 1.5% and 1.15%
for 60-day moving averages. The longer the time period, the more reliable
is the result, unless there are clear trends that render older data obsolete,
which is not the case here. Therefore, the 260-day moving average of 3.2%
is the best measure of the VRP in this study. These are lower premiums
than those in the Lease, McConnell, and Mikkelson study, although the
mean VRP was monotonically increasing with the length of the moving-
average time period (the authors also presented data for 120- and 180-
day moving averages. Given the reported results, it is possible that ex-
panding the time horizon would have led to a larger VRP.
The authors point out anecdotally that the voting rights premium
can be affected by other factors. They mentioned that until the fourth
quarter of 1994, the Class A stock of Paci¬care Health Systems, Inc. was
included in the S&P 400 index. During this time, the Class A voting shares
consistently traded at a 1.5“2.5% premium over the nonvoting shares.
During the fourth quarter 1994, the Class B nonvoting stock replaced the
Class A stock in the S&P 400 index. Since then, Class A traded at a 1.5%
discount to the nonvoting shares. The authors conclude that the visibility
of the stock, not its voting rights, accounted for its premium.
Another example they give is Playboy Enterprises, whose Class A
voting shares also trade at a discount from the nonvoting shares. How-
ever, the company™s largest shareholder owns over 70% of the Class A
voting stock. Institutional investors are interested in liquidity and prefer
to trade in the Class B stock, which has higher trading volume. The au-
thors conclude that the liquidity difference appeared to account for the
voting rights discount. Their ¬nal conclusion is that the 5.4% voting rights
premium in Lease, McConnell, and Mikkelson is too high, given their
more current data.
The anecdote about the liquidity difference depressing the voting
rights premium is consistent with Megginson (1990), where it was far
more obvious in the British markets. My conclusion from this is that the
3.2% voting rights premium would likely be higher after adjusting for
liquidity differences.

International Voting Rights Premia
Maher and Andersson (1999) refer to a number of articles that deal with
voting rights premia.22 Zingales (1995) ¬nds that while the voting rights
premium in the US is normally small, it rises sharply in situations where


21. In their chapter, they say as of December 31, 1994. However, I assume their use of moving
averages means that it is a span of time ending on that date.
22. I was unable to obtain those articles before this book went to press.




CHAPTER 7 Adjusting for Levels of Control and Marketability 219
control is contested, from which he infers that control shareholders re-
ceive private bene¬ts at the expense of minority shareholders.
The remaining evidence in this section is from other countries, where
concentrated ownership is the norm. Rydqvist (1987) ¬nds a 6.5% voting
rights premium for Sweden. Levy (1982) ¬nds a 45.5% VRP in Israel,
Horner (1988) ¬nds a 20% VRP for Switzerland, and Zingales (1994) ¬nds
an 82% VRP on the Milan Stock Exchange. The large voting premium in
Italy suggests high private bene¬ts of control, and Zingales (1994) and
Barca (1995) suggest that managers in Italy divert pro¬ts to themselves
at the expense of nonvoting shareholders. Zingales also measures the av-
erage proportion of private bene¬ts to be around 30% of the ¬rm value.
Zingales (1994) conjectures that the private bene¬ts of control in Italy are
so large because the legal system is ineffective in preventing exploitation
by controlling shareholders.

Bradley, Desai, and Kim (1988)
The authors document that successful tender offers increase the combined
value of the target and acquiring ¬rm by an average of 7.4% over the
period 1963“1984. In this article the 7.4% remains stable over the entire
22 years of analysis, which the Maquieira, Megginson, and Nail results
(in the next section) do, too. However, there was a constant movement
over time for the target shareholders to capture the lion™s share of syn-
ergies, with the acquirer faring worse over time. Also noteworthy is that
the authors present theoretical arguments why multiple-bidder contests
lead to larger payments to target stockholders.
The breakdown of the 7.4% overall synergy is very important to busi-
ness appraisers. The targets, who are, on average, 20% of the combined
entity (i.e., one-fourth of the size of the bidders), experienced an average
31.8% synergistic gain, as measured by cumulative abnormal returns
(CARs), and the bidders experienced a 1% synergistic gain. However, the
speci¬c results in different subperiods varied and will be signi¬cant in
my synthesis and analysis later in the chapter. The acquirers had CARs
of 4.1%, 1.3%, and 2.9% for July 1963“June 1968, July 1968“December
1980, and January 1981“December 1984, respectively. There is a clear
downward trend in the synergistic gains of the acquirers.
They also presented data showing that targets experience cumulative
abnormal returns (CARs) of 9.8% from ¬ve trading days before the an-
nouncement of the ¬rst bid to ¬ve trading days after the announcement.
A multiple bidding scenario increases the CARs by an absolute 13.0%,
which is consistent with the result from Schwert discussed above, al-
though not directly comparable in magnitude. Another interesting ¬nding
is that synergies were higher in multiple-bidder scenarios. As to the na-
ture of the synergies, the authors cite work (Eckbo 1983, 1985 and Stillman
1983) that indicates that the corporate acquisitions have no measurable
effect on the ¬rm™s degree of market power in the economy. This is con-
sistent with Maquieira, Megginson, and Nail™s results, discussed imme-
diately below, that the synergies are operating and not ¬nancial.

Maquieira, Megginson, and Nail (1998)
The authors examine wealth changes for all 1,283 publicly traded debt
and equity securities in 260 pure stock-for-stock mergers. They ¬nd non-



PART 3 Adjusting for Control and Marketability
220
conglomerate mergers create ¬nancial synergies. They de¬ne conglom-
erate mergers as those mergers in which the ¬rst two digits of the SIC
code of the acquirer and the target are different. They determine the SIC
code by examining the primary line of business listing for each company
in the relevant edition of the Moody™s manual. This data source differs
from Roach (1998), described earlier, and the SIC code scheme is different,
which may explain their different results.
To compute the synergy from the mergers, the authors used data
from two months before the merger to predict what would have been the
value of the two companies (and their individual classes of equity and
debt) as separate entities two months after the merger. They then added
the two separate company values together to form a ˜˜predicted value™™
of the merged entity. From this, they subtracted the actual market valu-
ation of the merged entity at two months after the merger, and they call
this difference the valuation prediction error (VPE), as well as the mea-
sure of synergy.
The mean and median VPEs for common and preferred stock were
8.58% and 8.55% for nonconglomerate mergers”and statistically signi¬-
cant at the 1% level”while they were 3.28% and 1.98% for conglomerate
mergers”and statistically insigni¬cant. For all classes of securities, which
also include convertible and nonconvertible preferred stock and bonds,
the mean and median net synergistic gains were 6.91% and 6.79% for
nonconglomerate mergers”and statistically signi¬cant at the 1% level”
while they were 3.91% and 1.25% for conglomerate mergers”and statis-
tically insigni¬cant. The positive VPEs in nonconglomerate mergers occur
in a statistically signi¬cant 66.4% of the mergers, while a statistically in-
signi¬cant 56.3% of the conglomerate mergers yield positive VPEs.
The breakdown between acquirers and targets is signi¬cant. In non-
conglomerate mergers, the acquirers had mean and median VPEs of
6.14% and 4.64%, while the targets were at 38.08% and 24.33%. In con-
glomerate mergers, the acquirers were the only losers, with mean and
median VPEs of 4.79% and 7.36%.
Maquieira, Megginson, and Nail also mention similar synergy ¬gures
provided by Lang et al. (1991), Eckbo (1992), and Berkovitch and Naray-
anan (1993). Another very signi¬cant conclusion of their analysis is that
the stock-for-stock merger synergies are operating synergies, not ¬nancial.
The authors also report the time to complete each merger, which are
interesting data and provide a benchmark for the delay-to-sale compo-
nent of my economic components model, described later in the chapter.
The time to complete the mergers ranged from a low of 11 months to a
high of 31 months”roughly 1 to 2 1/2 years. This underestimates the
time to complete a merger, as it starts from the announcement date rather
than the date at which the parties ¬rst thought of the idea.

Other Corporate Control Research
This section is brief. Its purpose is to present summary ¬ndings of other
researchers that will ultimately add to the discussion of what business
appraisers need to know about corporate control.
Franks and Harris (1989) analyze 1,445 takeovers in British stock
markets using the London Share Price Database. Their ¬ndings are very



CHAPTER 7 Adjusting for Levels of Control and Marketability 221
similar to those in the United States discussed in the previous sections,
i.e., that targets capture the majority of the gains from acquisition.
Cumulative abnormal returns (CARs)23 to the target shareholders in
Month 0 for single bids for which there were no revisions and no contest
were 20.6% and CARs for contested bids were 29.1%, for a differential of
8.5%. This is fairly similar, although somewhat lower than Schwert. The
CARs for Months 4 to 1 are much higher: 27.4% for the single bids
and 46.6% for contested bids, for a differential of 19.2%, which is higher
than Schwert™s result. There is an interesting intermediate category of
revised, but uncontested, bids, which the authors say probably re¬‚ects
results when the buyers are worried that another ¬rm might compete
with their initial lower bid. The CARs for this category are 28.7% in
Month 0 and 40.5% for Months 4 to 1. These might provide interesting
benchmarks for different levels of competition, both actual and potential.
CARs to bidders are very low, which echo the US results.
In a cross-sectional analysis of total wealth gains, multiple bidders
increase the control premium by an absolute 8.44%.24 This is also similar
to Schwert™s result, although slightly lower.
Harris (1994) provides an explanation of why any ¬rm would want
to be the bidder rather than the target. If target shareholders are the big
winners and bidders barely break even, then why bother being a bidder?
Why not wait for the other ¬rm to be the bidder and be the target instead?
The answer is that while the target™s shareholders are the winners, the
target™s management are losers. Harris cites another author who cites a
Wall Street Journal article that reported 65% of a sample of 515 target CEOs
left their ¬rms shortly after the acquisitions (less so in mergers). The re-
ward for the bidder is that management gets to keep their jobs. The re-
ward for target management is that the bidder pays a high price for their
stock, which gives many of them plenty of time to take life graciously
while looking for their next job.


Menyah and Paudyal
This research provides a method of quantifying the bid“ask spread (BAS).
Later in the chapter we review some of the work on DLOM by Larry
Kasper, which involves using an econometric equation to determine the
BAS to add to the CAPM-determined discount rate before DLOM. Those
interested in using Kasper™s method may want to understand this re-
search. Otherwise, this work is not used in my own models and can be
skipped.
The authors study stocks on the London Stock Exchange and ¬nd
the security prices, volume of transactions, risk associated with security
returns, and the degree of competition among market makers explain 91%
of the cross-sectional variations in bid“ask spreads (BAS) (Menyah and
Paudyaul 1996).



23. The authors actually use the term total abnormal returns.
24. See the x-coef¬cient for variable 2 in their Table 9.




PART 3 Adjusting for Control and Marketability
222
The average inside spread25 for liquid stocks was 0.83% before the
October 1987 stock market crash. It increased to 2% but has since declined
to 0.71% by the end of 1993. The average inside spread for less liquid
stocks declined from 10% to 6% over the same period. Transactions over
£2000 have lower BASs.26
The academic literature has identi¬ed three components to the BAS:
order processing, inventory adjustment, and adverse information. The au-
thors quote Stoll (Stoll 1978a, b), who says that because dealers must
service their customers, they cannot maintain an optimal portfolio suit-
able to their risk“return strategy. Therefore, total risk, not just systematic
risk”as measured by beta”is the relevant variable in determining the
BAS.
Their regression equation is: ln BAS 0.097 0.592 ln Price
0.649 ln 0.369 ln # Market Makers 0.209 ln Volume. All coef¬cients
were signi¬cant at the 5% level, except the y-intercept. R 2 91%.
The BAS equation shows that in the public markets, an increase in
volatility increases the BAS”and thus DLOM”while an increase in the
number of market makers decreases BAS and DLOM. With privately held
¬rms, there is no market maker, i.e., a dealer who is willing to buy and
sell. Business brokers and investment bankers never take possession of
the ¬rm. This is an substantial intellectual problem for one wishing to
use this model. Nevertheless, it may provide some useful benchmarks.


My Synthesis and Analysis
Trying to make sense of the oceans of research and opinions is like trying
to put together a giant picture puzzle. For a long time it was dif¬cult to
see where some of the pieces ¬t, and some did not seem to ¬t at all.
However, some coherence is beginning to form.

Decomposing the Acquisition Premium
Let™s begin by decomposing the acquisition premium into its potential
components:
1. Performance improvements.
2. Synergies.
3. Control premium, i.e., the pure value of control.
Performance improvements are the additional expected cash ¬‚ows
from the target when the bidder runs the target more ef¬ciently. In val-
uation profession parlance, synergies mean the additional value that
comes from combining the target with the bidder”let™s call that pure
synergy. Speci¬cally, it is that portion of the pure synergy in the control


25. The best bid and offer prices at which market makers are prepared to deal in speci¬ed
quantities are quoted on the yellow strip of the Stock Exchange Automated Quotation
(SEAQ) screens.
26. Commission rates are also lower since 1986. In 1991 the commission rate for small trades was
2% of transaction value, while trades over £1 million incurred commissions of 0.15% and
declined further in 1993 to 0.13%.




CHAPTER 7 Adjusting for Levels of Control and Marketability 223
premium for which the bidder pays. We never see the portion that the
bidder keeps in the Mergerstat acquisition premiums.27 However, in the
academic literature cited, synergy is used to mean the increase in value
of the combined entity regardless of the source. It is the combination of
the added value from performance improvements and pure synergy.28
Ideally, if we could quantify each component, we would want to
apply only the pure control premium, item 3, to a marketable minority
interest fair market value (FMV) to arrive at a marketable control FMV.
We would not want to apply the average amount of performance im-
provements in the market to a subject company, as it is more appropriate
to quantify the speci¬c expected performance improvements for the sub-
ject company and add those to the forecast cash ¬‚ows. This follows Mer-
cer (1998) and McCarter and Glass (1995). Finally, synergies normally
belong in investment value, not fair market value”unless the market is
dominated by strategic buyers and the subject company is a serious can-
didate for the M&A market.

Inferences from the Academic Articles
The Bradley, Desai, and Kim results are very revealing. On average over
22 years, the acquirers actually gained, with a CAR of 1%. This means
that the acquirers are not paying for control! They are paying for expected
cash ¬‚ows. There is no information in this article to tell us how to break
down the CAR to the target between performance improvements and
synergies. However, the Maquieira, Megginson, and Nail article provides
some information to enable us to do that. The VPEs for the nonconglom-
erate acquirers were about 11% higher than they were for the conglom-
erate acquirers, which suggests that synergies account for the entire pre-
mium. Bidders are approximately four times the size of the targets in
their study.29 Multiplying the VPE differential of 11% 4 44% attrib-
utable to synergies. Since acquisition premiums are rarely even that large,
this is evidence that acquisition premiums are being paid exclusively for
pure synergies and not for performance improvements.
The Roach article suggests the opposite”that the majority of the
increase should be from performance improvements, since there was no
pattern to the acquisition premiums by the difference in SIC codes. The
two articles used different schemes for determining a potential synergistic
merger. Maquieira, Megginson, and Nail only require that the two ¬rms
be in the same two-digit SIC code. A merger of SIC codes 3600 and 3699
would be nonconglomerate, while in Roach™s work they would be a dif-
ference greater than 50 and presumably the equivalent of conglomerate,
although he did not use that terminology. On the other hand, a merger


27. That also would be true about the portion of performance improvements that the bidder keeps.
28. We could add valuation corrections for underpricing errors to the previous list. To the extent
that bidders spot undervalued ¬rms and pay a premium for some or all of that
undervaluation, that portion does not belong in the control premium applicable to private
companies, as we already presume that the valuation before discounts and premiums was
done correctly.
29. The book value of total assets of the bidding ¬rms made up 81.2% of total assets of both ¬rms
combined, and the targets made up 18.8% of total assets.




PART 3 Adjusting for Control and Marketability
224
of SIC codes 3599 and 3600 would be a conglomerate merger according
to Maquieira, Megginson, and Nail, but a difference of one in the SIC
code in Roach™s work. It is logical that one can achieve synergies from
combining two ¬rms in similar but different businesses and that the two-
digit SIC code scheme is better for that purpose. For our analysis, we will
assume that the academic article is the more correct approach.30
Strong evidence supports this conclusion that acquirers are paying
for synergies and not control in Table 7-4, which compiles Mergerstat
acquisition premiums for control and minority interests. The average dif-
ference of control and minority purchase acquisition premiums was
0.16% (K7), and the average minority-to-control ratio was 99.11% (K8).31
If acquisition premiums were really measuring the value of control, then
minority interest acquisitions should have had a signi¬cantly lower pre-
mium. Instead, this is strong evidence that acquisition premiums are mea-
suring synergies, not control.
Back to Bradley, Desai, and Kim, in the 1981“1984 subperiod, the
acquirers did suffer a loss of 2.9%, as measured in CARs. This could mean
that the acquiring ¬rms were willing to suffer a net loss of 2.9% of market
capitalization for the privilege of control over the target. Since targets
were, on average, about one-fourth the size of the bidders, this translates
to 11.6% of target value. However, 4 years out of 22 does not seem enough
to assert strongly that this is a reliable control premium”let alone the
control premium.32
The Maquieira, Megginson, and Nail article provides similar results.
The only negative VPE was for the acquirers in conglomerate mergers,
who had a mean and median VPE of 4.79% and 7.36%. Multiplying
that mean VPE by four for the bidder-to-target size ratio leads to a pos-

T A B L E 7-4

Mergerstat Mean Premiums: Control versus Minority Purchases


A B C D E F G H I J K L

4 1990 1991 1992 1993 1994 1995 1996 1997 1998 Average
5 Control interest [1] 42.3% 35.4% 41.3% 38.7% 40.7% 44.1% 37.1% 35.9% 40.7%
6 Minority interest [1] 39.6% 32.6% 38.3% 38.3% 54.5% 61.7% 29.4% 22.4% 39.5%
7 Difference 2.7% 2.8% 3.0% 0.4% 13.8% 17.6% 7.7% 13.5% 1.2% 0.16%
8 Minority/control interest 93.6% 92.1% 92.7% 99.0% 133.9% 139.9% 79.2% 62.4% 97.1% 99.11%
← Total
9 SYD weights 2.8% 5.6% 8.3% 11.1% 13.9% 16.7% 19.4% 22.2% 25.0% 100.00%
10 SYD difference 0.1% 0.2% 0.3% 0.0% 1.9% 2.9% 1.5% 3.0% 0.3% 0.17%
11 SYD minority/control 2.6% 5.1% 7.7% 11.0% 18.6% 23.3% 15.4% 13.9% 24.3% 97.63%
13 # Transactions
14 Control interest 154 125 127 151 237 313 358 480 506
15 Minority interest 21 12 15 22 23 11 16 7 6

[1] Mergerstat 1999, Table 1-17, Page 25 (Mergerstat 1994, Figure 43, Page 100 for 1990-1993). Mergerstat is a division of Houlihan Lokey Howard & Zukin.




30. This is not to denigrate Roach™s work, which was very creative and is still signi¬cant evidence.
I made the same mistake in my own research.
31. In the data provided to me by Mergerstat, the average size of minority purchase was 38%.
32. Even though the regression coef¬cient was signi¬cant at the 0.01 level.




CHAPTER 7 Adjusting for Levels of Control and Marketability 225
sible control premium of 19.2% of the target™s pre-announcement value.
Perhaps this is a subset of the market that is paying something for pure
control, but it is not representative of the market as a whole.
Thus, it appears that our tentative conclusion, that the 7.4% differ-
ence between acquisition premiums in ordinary acquisitions and going
private premiums represents synergies, appears to be incorrect. However,
it is still possible that going private premiums might be the true control
premium. We will come back to this question.

The Disappearing Control Premium
Let™s consider the acquisition process. Conventional wisdom is that Com-
pany A buys control of Company B and pays, say, a 40% premium for B.
Therefore, B is worth 40% more on a control basis than on a marketable
minority basis. However, what happens after the acquisition? B no longer
exists as an entity. It is absorbed into A, which itself is a public ¬rm
owned by a large number of minority shareholders.
How can one justify the 40% premium to the shareholders of A?
Won™t the minority shareholders of A lose? If it is true that A is paying
purely for the control of B, then yes, they will lose, because the minority
shareholders of A pay for control that they ultimately do not receive.
Paying for control means that the buyer is willing to accept a lower rate
of return in order to be in control of the seller, and the Bradley, Desai,
and Kim results do not support that contention.33 After the acquisition,
who is in control of B? The management of A is in control, not the share-
holders of A. For there to be a pure value of control, it must go to man-
agement, who may enhance their salaries and perquisites for running a
larger organization. It makes sense that if ¬rms are paying for control
anywhere, it is in conglomerates. That only goes so far, though, before
the shareholders revolt or another ¬rm comes along and makes a hostile
takeover, booting out the inef¬cient management team (or a team who
looks after its own interests at the expense of the shareholders).
This seems to suggest that Mercer (1998) and McCarter and Glass
(1995) are correct. There is no value to control in itself. The appraiser
should simply try to quantify the performance improvements that one
can implement in the subject company, if they are relevant to the purpose
of the valuation, and proceed with the discounted cash ¬‚ow or guideline
company valuation. The difference in the marketable minority value and
the ˜˜control value™™ comes from the changes in cash ¬‚ows, not from a
control premium.

The Control Premium Reappears
Does this mean there is no such thing as a value to control? No. It™s just
that we cannot ¬nd it directly in the U.S. M&A market or in the public
markets, with the possible exception of the conglomerate mergers in the
Maquieira, Megginson, and Nail article. The reason is that there has to
be one individual or a small group of individuals34 actually in control


33. Again, with the possible exception of the 1981“1984 period.
34. Henceforth, for ease of exposition, reference to one individual in this context will also include
the possibility of meaning a small group of individuals.


PART 3 Adjusting for Control and Marketability
226
who derive psychic bene¬ts from it for there to be a pure control pre-
mium”and there is no such thing in the United States”almost.

Estimating the Control Premium
We begin the process of estimating the control premium by starting with
the voting rights premium (VRP) data, which show that there is a value
of the vote to individual shareholders. If the vote has value, then logically
control must have more value”but again only to an individual who is
really in control.
Our VRP analysis shows two levels of voting rights premium. The
gross premiums were 5.4% and 3.2% in the United States from the Lease,
McConnell, and Mikkelson study and the HLHZ study, and 13.3% in
England, per Megginson (1990). The net premiums”meaning those
above and beyond expected higher cash ¬‚ows to the voting stock”were
1“1.4%. For the valuation of most small and medium-size businesses, the
gross VRP is the more relevant measure, for reasons we will discuss
shortly.
The U.S. gross VRPs average 4.3%, i.e., the average of the 5.44% and
3.2% gross VRPs from Lease, McConnell, and Mikkelson and HLHZ ar-
ticles. According to Professor Megginson, we then need to add another
2% to 3%, say 2.5%, for the depressing effect on the VRP of the illiquidity
of the voting shares, which brings us to 6.8%, which we round to 7%.
Control must be worth at least three to four times the value of the
vote. That would place the value of control to an individual at at least
21“28%. It could easily be more. Currently, the only possible direct evi-
dence in the United States is the conglomerate control premium of 19.2%
in the Maquieira, Megginson, and Nail article, which is very close to the
above estimate. The VRP in Switzerland, Israel, and Milan of 20%, 45.5%,
and 82%, respectively, is another indication of the value of control when
minority shareholders are not well protected, again keeping in mind that
those were the value of the vote, not control.
Another piece of data indicating the value of control is the one outlier
in the Lease, McConnell, and Mikkelson study, which had a 42% VRP.
Such a high VRP in the United States is probably indicative of control
battles taking place and could rapidly reduce to a more normal VRP.
Thus, the voting shareholders probably could not rely on being able to
resell their shares at a similar premium at which they buy. That 42%
premium is evidence of the value of the vote in an extreme situation when
small blocks of shares would have a large impact on who has control.
The reason why the gross VRP is relevant for most businesses in the
process of inferring the value of control is that as long as the buyer of a
business can turn around and sell the business for the same control pre-
mium as he or she bought it, there is no loss in net present value of cash
¬‚ows, other than the pure control portion, which derives from the net
VRP.35 The buyer will eventually recoup the control premium later on as
a seller. That works as long as the business is small enough that its buyers


35. There is actually a second-order effect where this is not literally true. To the extent that the
owner is taking implicit dividends in the form of excess salary, there is some loss in present
value from this.


CHAPTER 7 Adjusting for Levels of Control and Marketability 227
will be either private individuals or private ¬rms. If the business grows
large enough to be bought by a public ¬rm or undergoes its own IPO,
then instead of recouping a private control premium, the owner may
receive an acquisition premium with synergies in the case of a buyout.
In the case of an IPO, the company will experience an increase in value
from increased marketability.36 Also, while the control premium will be
smaller, DLOM may also be smaller.
The best source of data for control premiums and DLOC for private
¬rms in the United States will probably come from a thorough analysis
of the international literature. The publicly traded ¬rms overseas are
probably better guidelines to use to understand the value of control than
United States ¬rms for two reasons. The ¬rst reason is that in most foreign
countries”especially those outside the United Kingdom”ownership of
public ¬rms is far more concentrated than it is in the United States. The
second reason is that the minority shareholders there are far more vul-
nerable to abuse by the control interests, which is closer to the case in
privately held ¬rms in the United States.
Unfortunately, that will have to remain as future research. In the
meantime, I would suggest that the 21“28% control premium based on
the gross VRP is probably reasonable to add to a marketable minority
FMV”at least for small and medium ¬rms. For large private ¬rms, that
range may still be right if a synergistic buy is likely in the future. Oth-
erwise, it is probably more appropriate to use a smaller control premium
based on the net VRP, which would be in the 3“6% range.
At this point, we need to compare our control premium inferred by
VRPs with going private premiums, as the latter is also a candidate for
our measure of the value of control. The median going private premium
of 24.1% (Table 7-1, E21) is right in the middle of our 21“28% range for
control calculated by VRPs. However, the mean going private premium
of 32.1% (Table 7-1, D21) is above our VRP-calculated range. Which is
more likely to be right?
The going private premiums have the advantage of being directly
calculated rather than indirectly inferred, so that is one point in their
favor. There is no consensus in the valuation profession in general
whether medians or means are better measures. All other things being
equal, then, it would make sense to use the median, as it is consistent
with the VRP-calculated control premium. I more often use means than
medians, which leaves me a little dissatis¬ed relying solely on the con-
sistency of the two measures.
There is other logic that convinces me that the lower measure of
control is more correct. What are the motivations for going private? The
management team may believe:
(1) The company is underpriced in the market.
(2) Removing the burdens of SEC reporting will increase
pro¬tability.


36. The appraiser must consider the issue of restricted stock discounts in this case.




PART 3 Adjusting for Control and Marketability
228
(3) If the going private transaction is a division of a public
company, it can operate more ef¬ciently without interference
and the burden of overhead from the corporate people.
(4) The management group and the buyout group want to be in
control of the company.
Item (1) implies that the universe of going private transactions may
have a sample bias with respect to the valuation of privately held ¬rms.
However, to the extent that (1) is true, that portion of the control premium
is inapplicable to the valuation of private ¬rms, as we presume that the
valuation is done correctly up to this point. Item (2) is also inapplicable
to the valuation of private ¬rms, as this represents a performance im-
provement to the going private ¬rm that is unavailable to the ¬rm that
has always been private. Therefore, that portion of the going private pre-
mium represented by the economic ef¬ciencies of being private also does
not belong in our calculation of the value of control.
Item (3) is a performance improvement and not really a value of
control itself. It represents improvements in cash ¬‚ow, and thus could be
considered a control premium to the extent that we believe that the av-
erage going private ¬rm would achieve the same amount of performance
improvements that an already private ¬rm could expect with new man-
agement, but I ¬nd that very speculative.
A direct measurement of the premium associated with item (4) would
be the closest to our VRP approach to calculating the value of control.
However, I ¬nd it hard to believe that there is a single shareholder who
is in control in the large going private transactions recorded in Mergerstat.
Who is in control of the buyout group? Management?
I think that the composition of the observed going private premium
is a mixture of all four items above and probably others of which I am
unaware. It is likely that some of the going private premium is irrelevant
to the valuation of private ¬rms, some of it is for performance improve-
ments that might be applicable to private ¬rms, and some is for the value
of control itself, although the latter certainly is less for going private trans-
actions than it is for true control of a ¬rm by a single individual.
Let™s make a wild guess as to how the four components comprise
the going private premium. Suppose each item is one-fourth of the pre-
mium, i.e.:
(1) Company underpriced 8%
(2) Remove SEC reporting 8%
(3) Eliminate corporate overhead 8%
(4) Control 8%
Total”Mean 32%
If this were the true breakdown of the going private premium, then the
value of pure control would be only 8%. But, perhaps that is reasonable
in a situation where control is not concentrated in a single individual but
rather is spread among a few people in the buyout group and a few
people in management. This would tell us fairly little about how to apply
it to an already private company.




CHAPTER 7 Adjusting for Levels of Control and Marketability 229
Ultimately, I am more comfortable with the VRP inference of the
value of control than the going private premium, as it makes a clean
separation of performance improvements from control. In any case, it
seems clear that the mean going private premium is probably too high
as a measure of the value of control, and we should stick with the 21“
28% control premium.

DLOC
It is my opinion that Nath is correct in his assertion that both DLOM and
DLOC are needed from the marketable minority interest.37 Bolotsky dis-
agrees with this more in form than in substance. He asks”logically
enough”how one can subtract a DLOC from an interest that has no
control attributes to it. The answer is that control matters much less in
publicly held ¬rms in the United States than it does in privately held
¬rms. The public minority shareholder has little fear of control share-
holders ruining the company or abusing the minority shareholders. Even
if he or she does, there are remedies such as class action lawsuits, take-
overs, shareholder meetings, etc. that the private minority shareholder
can only wish for.
I suggest that Bolotsky™s 2 2 levels of value chart, as depicted in
38
Figure 7-2, is still too simple. Using his own very innovative and per-
ceptive framework of differing shareholder attributes, it is possible to see
why it may still be appropriate to subtract an incremental DLOC in val-
uing a private minority interest. Figure 7-3 is my own expansion of Bol-
otsky™s 2 2 levels of value chart. Here I have split minority interests
into well treated and exploited. Most U.S. public minority interests are
well treated, and the values are in row 2, column 2 of Figure 7-3. Most
private minorities in the United States are poorly treated or, if not, may
have to fear being poorly treated with a change in control ownership or
a change in attitude of the existing owners. Thus, most U.S. private mi-
norities are in row 3, column 2. The DLOC calculated as the ¬‚ip side of
the control premium going from a well-treated minority to control is in-
suf¬cient to measure the lower position of an exploited minority. You will


F I G U R E 7-3

3 2 Levels of Value Chart


Public Private

Control x x
Minority (well treated) x x
Minority (exploited) x x




37. This distinction is more important vis-a-vis Mercer™s original position than it is in using his
`
quantitative marketability discount model.
38. In fairness, his 2 2 levels of value chart is his own simpli¬cation of his more complicated
system.




PART 3 Adjusting for Control and Marketability
230
see this later in the chapter in the section on international voting rights
premia, where we examine the difference in market value of voting versus
nonvoting stock in international public markets. When minority rights
are poorly protected, the voting rights premium is as high as 82%, i.e.,
voting stock sells for an 82% higher price than nonvoting stock. Control
must be very valuable in Milan!
It often may be appropriate to use control premia from other coun-
tries to calculate a DLOC that is appropriate for U.S. minorities. Then one
can use Jankowske™s formula to make the incremental adjustment. Thus,
it is my opinion that we should subtract both an incremental DLOC and
DLOM from the marketable minority value to arrive at a private minority
value. However, this is an area that requires further research.
It is important to understand that those are not six unique and dis-
crete cells in the ¬gure. While public or private is an either/or concept,
both the degree of control and how well treated are the minority interests
are continuums. Thus, there are not only six values that one could cal-
culate as DLOM, but an in¬nity of values, depending on the magnitudes.
In my correspondence with Mike Bolotsky, he agrees in substance
with this view. He prefers to think in a multidimensional matrix of fac-
tors, labeled something like ˜˜SEC oversight and enforcement power,™™ in-
stead of a control issue. Even so, I will quote from his letter to me. ˜˜In
valuing private minority interests that are either poorly treated, which is
typical of most, or even have reason to fear being poorly treated, I think
it is reasonable to subtract DLOC. However, we cannot learn what that
is from the American public stock markets, where minority interests are
well protected administratively and legally.™™ I agree completely.
That is a research task to be done in the future. In the meantime, the
above simpli¬cation works and is easier than a multifactor matrix.
What measure of control premium should we use to calculate DLOC?
Starting with a marketable minority FMV, we have to decide whether we
are coming down to a well-treated private minority or an exploited pri-
vate minority interest. Additionally, even a well-treated private minority
today may turn into a poorly treated minority tomorrow, and the fear of
that alone should create a positive DLOC from the marketable minority
level. I would suggest again that the 40% range for the foreign VRPs and
the American outlier in the Lease, McConnell, and Mikkelson study
(which, by coincidence, are similar to American acquisition premiums)
plus some additional amount for control being more valuable than the
vote, is a reasonable range from which to calculate DLOC. One caveat: if
you are valuing an ˜˜exploited™™ minority interest and have not added back
excessive salaries taken by the control shareholders, the 40 % range con-
trol premium would translate to a 28.6% DLOC, which might be exces-
sive, depending on the magnitude of excessive salary. The reason for this
is that the 40 % VRP may, to some extent, represent excess salaries to
holders of voting shares. Therefore, if we have already accounted for it
in the discounted cash ¬‚ow, we do not want to double-count and take
the full discount.
It is important to note that, given the previous analysis, I do not
consider the decrease in value from a public ˜˜control™™ value to a mar-




CHAPTER 7 Adjusting for Levels of Control and Marketability 231
ketable minority level to be DLOC. It tells us nothing about control. It
only tells us the magnitude of synergies in acquisitions. I would not use
it go from a private control interest to a private minority interest.

DISCOUNT FOR LACK OF MARKETABILITY (DLOM)
Three quantitative models for calculating DLOM have appeared in the
professional literature: Jay Abrams™ economic components model
(Abrams 1994a),39 Z. Christopher Mercer™s quantitative marketability dis-
count model (Mercer 1997), and Larry Kasper™s discounted time to market
model (Kasper 1997). In this section we will review Mercer™s and Kasper™s
work. In the next section we will cover Abrams™ model in greater depth.

Mercer™s Quantitative Marketability Discount Model
Mercer presents the quantitative marketability discount model (QMDM)
in his impressive volume devoted entirely to the topic of discount for
lack of marketability. His book contains much important research in the
¬eld and does an excellent job of summarizing prior research and iden-
tifying and discussing many of the important issues involved in quanti-
fying DLOM. I consider his book mandatory reading in the ¬eld, even
though I will present my own competing model that I contend is superior
to the QMDM. I will not attempt to give more than a bare summary of
his work”not because it is not important, but for the opposite reason: it
is too important to be adequately represented by a summary.
With that caveat in mind, the QMDM is based on calculating the net
present value of forecast cash ¬‚ows to shareholders in a business entity.
His key concept is that one can evaluate the additional risk of minority
ownership in an illiquid business entity compared to ownership of pub-
licly traded stock and quantify it. The appraiser evaluates a list of various
factors that affect risk (Mercer 1997, p. 323) and quanti¬es the differential
risk of minority ownership of the private ¬rm compared to the public
¬rm or direct ownership of the underlying assets”whichever is appro-
priate”and discounts forecast cash ¬‚ows to present value at the higher
risk-adjusted rate of return to calculate the discount.
To simplify the calculations, Mercer usually assumes a growing an-
nuity. He presents an approximate formula for the present value of an
annuity with growth (p. 276). In using the QMDM, one improvement the
appraiser can make is to use the exact annuity discount factors (ADFs)
with growth that we developed in Chapter 3 and that we repeat below.
n
1 1 g
ADF 1
r g 1 r
ADF with perpetual growth: End-of-year formula (3-6b)
n
1 r 1 g
ADF 1
r g 1 r
ADF with perpetual growth: midyear formula (3-10a)


39. There is no name for the model in the article cited. I have named it since.




PART 3 Adjusting for Control and Marketability
232
Note that the ¬rst terms on the right-hand-side of equations (3-6b) and
(3-10a) are the end-of-year and midyear Gordon models. As
n
1 g
n’ ’0
,
1 r
and the ADF reduces to the Gordon model with which we are all familiar.
In his Chapter 12, Mercer reiterates his opposition to a DLOM for
controlling interests from his original article (Mercer 1994). His primary
objection seems to be that the control owner has control of cash ¬‚ows
until he or she sells the business, at which time there is no longer DLOM.
I disagree, as the ability to enjoy cash ¬‚ows one day at a time and to
instantaneously actualize the present value of all cash ¬‚ow to perpetuity
are quite different, the difference being measured by the DLOM that Mr.
Mercer suggests does not exist.
In support of his belief that a DLOM is inappropriate for a controlling
interests, Mercer (p. 340) cites an article (Phillips and Freeman 1995) that
¬nds that after controlling for size, margin, and industry, privately held
¬rms do not sell for lower multiples than publicly held ¬rms when the
buyer is another publicly held ¬rm. There are a few problems with this
study:
1. Since the buyers are all publicly held ¬rms, once the sellers™
businesses are absorbed into the buyers™, there is no DLOM that
applies anymore. When a privately held ¬rm sells to a publicly
held ¬rm, ignoring any other differences such as potential
synergies, there are at least two FMVs for the seller: a ˜˜¬‚oor
FMV,™™ which is the FMV of the standalone business, including
DLOM, and a ˜˜ceiling FMV,™™ which is the FMV without DLOM.
The seller should not be willing to sell below the ¬‚oor FMV, and
the buyer should not be willing to pay more than the ceiling
FMV. An actual transaction can take place anywhere between
the two, and Mergerstat will record that as the FMV. The articles
by Schwert (1996) and Bradley, Desai, and Kim (1988) cited
earlier in this chapter show that the lion™s share of excess
returns in acquisitions go to the seller. Thus, it is normal that
the buyer pays top dollar, which would mean that the seller
would insist that the buyer forgo the DLOM, which disappears
in any case after the transaction. Therefore, at a minimum, the
Phillips/Freeman article™s applicability is limited to privately
held ¬rms that are large enough to attract the attention of and
be acquired by publicly held buyers.
2. In both regressions”the Mergerstat and the SDC database”
banks show up as having different valuations than all other
industries. However, the signs of the regression coef¬cients for
banks are opposite in the two regressions. The regression of the
Mergerstat database demonstrates at the 99.99% signi¬cance
level that buyers pay lower multiples of sales for banks than for
other industries, and the regression of the SDC database
demonstrates at the 99.99% signi¬cance level that buyers pay
higher multiples of sales for banks than other industries! There

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