Structuring a takeover - The control premium conundrum
PKF Corporate Finance is often asked to act as an Independent Expert in relation to takeover transactions, usually relating to publicly listed companies.
One issue which we are often required to address as an Independent Expert, but which is often overlooked by parties involved in the transactions, relates to the impact of control premiums and minority discounts on a transaction and in particular, our conclusions regarding “fairness” of a transaction. Getting this wrong can result in an unexpected negative opinion being expressed by the Independent Expert and as such, it is it important to seek professional advice when structuring any takeover offer prior to release to the market.
What is a “control premium” and “minority discount”?
When looking at the price that a company’s shares are trading at on a stock exchange, they represent prices that are being exchanged for minority interests in that company, i.e. equity interests which represent a very small portion of the company’s overall voting interests.
These values represent the fact that owners of these shares do not gain control of the company and do not, by themselves, have any control over the company’s cash flows, operations or dividend policies, to name a few.
A control premium represents the additional value that an acquirer is willing to pay over and above these minority values. This premium represents the fact that the acquirer will gain full control over the finances and operations of the target company. It may also represent some or all of the synergistic value that an acquirer expects to obtain from the acquisition.
Conversely, a minority discount represents the discount to the control value which is applied when valuing minority voting interests in a company.
The range of control premium and/or minority discount will vary from case to case. In Australia, it is typical to see control premiums ranging between 25% and 40%.
Cash vs scrip takeover offers – it does make a difference!
Understanding the difference that a cash vs scrip offer will have on the analysis undertaken by an Independent Expert is an important factor for takeover advocates.
Let’s have a look at the following example:
- Company A is proposing to acquire 100% of the issued shares of Company B.
- Company A has an equity value of $8m while Company B has an equity value of $2m. Both of these values incorporate a premium for control.
- Company A has offered $2m in cash to the shareholders of Company B.
In the above scenario, an Independent Expert is likely to conclude that the takeover offer is “fair” because the cash being offered is equal to the control value of Company B’s shares.
Now let’s assume that instead of cash, Company A offers shares in itself to the shareholders of Company B. The number of shares to be offered will represent 20% of the combined entity which was worked out by adding the equity values of Company A and Company B together (i.e. $8m + $2m = $10m) and working out the portion that Company B contributes the combined entity (i.e. $2m/$10m = 20%).
Whilst on the face of it this offer would appear to be “fair”, it is likely that an Independent Expert would conclude the opposite due to the fact that in a scrip-for-scrip takeover transaction, regulations imposed by the Australian Securities & Investment Commission (“ASIC”) require the Independent
Expert to compare (i) the equity value of Company B on a controlling interest basis with (ii) the equity value of the combined entity on a minority interest basis. This form of analysis recognises the fact that shareholders of Company B (collectively) are giving up a controlling interest (which they may otherwise be able to dispose of in a cash takeover offer) in exchange for a minority interest (individually) in the combined entity (which they will likely only be able to sell on the stock exchange for minority values).
In the above example, the Independent Expert would therefore conclude that as the equity value of Company B on a controlling interest basis (i.e. $2m) is less than a minority interest in the combined entity (i.e. 20% x $10m x minority discount), the takeover offer is “unfair”.
The above requirements can often be a trap for takeover advocates who believe that offering like for like value, will result in a “fair” opinion from an Independent Expert.
The Independent Expert may then determine that the offer is not fair but reasonable taking into account other factors including the minority valuation of Company B’s shares.
Exceptions to the rule.
ASIC regulations allow for one exception to the rule, and that is in the case of a merger of entities of equivalent value when control of the merged entity will be shared equally by between the bidder and the target.
It will be up to the Independent Expert to exercise his judgement and justify using an equivalent approach to valuing the securities of the bidder and the target.
Pre-Existing Bidder Interests – Another Common Trap
Another trap commonly missed, is in the situation where the bidder already holds a controlling interest in the target.
In this scenario, one might reasonably assume that as the bidder is only making an offer in relation to a minority interest of the target (even on a combined basis), the bidder does not need to offer a control premium as it already has control.
ASIC regulations require the Independent Expert to ignore existing ownership interests that the bidder holds in the target and enforces the rule that in valuing the securities of the target, it should be done so on a controlling interest basis. This applies to cash and scrip takeover offers.
What can takeover advocates do?
Independent Experts are prohibited from assisting takeover parties in relation to the structuring of transactions – an Independent Expert’s role should be just that, independent, and limited to reviewing the transaction proposal put forward to them.
Accordingly, when formulating a takeover offer, it is important for Boards to seek advice from financial professionals who are familiar with the requirements imposed on Independent Experts and valuation principals in general, prior to submitting the takeover proposal.