Among the compelling metrics compiled by Professors Korsmo and Myers in their article on appraisal rights that has been approvingly cited by the Delaware Court of Chancery, they have highlighted two key trends which, taken together, demonstrate the sophistication of the investors now driving what appears to be a pronounced spike in appraisal rights cases. Thus, the first graph (view here) shows the sharp increase in the number of petitions filed over the past decade, and the second graph (view here) shows the sheer size of the dollar amounts at stake.
Prior posts in our “Valuation Basics” series have examined the various components of the cost of equity capital under the Capital Asset Pricing Model (“CAPM”). In this post we continue our discussion of those components, focusing on the equity risk premium and its modifying coefficient, the beta.
The CAPM has become the Delaware Court of Chancery’s preferred method for calculating a company’s cost of equity (i.e., the rate of return an investor would demand in order to purchase the company’s stock). A company’s cost of equity under the CAPM is generally the sum of (1) a risk-free rate, plus (2) the equity risk premium adjusted by a beta, plus (3) a size risk premium.
The “equity risk premium” is the difference between the risk-free rate and the expected return from the market. That is, the equity risk premium predicts how a stock index will perform compared to a risk-free investment, such as a treasury bond. Because not all stocks listed on a particular index perform alike, an appraiser valuing a specific company typically adjusts the equity risk premium by a volatility metric called a “beta.” A company with a beta of 1.0 will have an equity risk premium in line with the market. A company with a beta higher than 1.0 will be more volatile than the market, and a company with a beta of less than 1.0 will be less volatile than the market.
Calculating the Equity Risk Premium
The Ibbotson SBBI Valuation Yearbook provides two methods for calculating the equity risk premium: historic and supply-side. The historic equity risk premium looks at stock market returns against risk-free returns dating back to 1926. The supply-side equity risk premium modifies the historic equity risk premium by adjusting the historic equity risk premium for any inflation included in the price-to-earnings ratio. The supply-side method thus produces a slightly lower equity risk premium than the historic method.
Although the historic equity risk premium is the more traditional method, in its recent appraisal opinions the Delaware Court of Chancery has embraced the supply-side equity risk premium as the prevailing methodology. In Global GT LP v. Golden Telecom, Inc., for example, the court adopted the supply-side method over the historic method because the weight of authority supported a rate of return that was closer to the supply-side equity risk premium.
Small variances in beta can lead to large discrepancies in the overall valuation of a company. For example, suppose an appraiser determines that, as of the merger date, the equity risk premium for Company X was 6%. A beta of 1.5 would increase that number to 9%. A beta of 0.5 would decrease that number to 3%. Assuming Company X had very little debt, this could lead to an almost 6% swing in the weighted average cost of capital. Not surprisingly, therefore, beta calculations are frequently contested in appraisal actions.
Although the historical market beta of a publicly traded company can be calculated by examining the covariance between the stock’s historical performance and that of the S&P 500, this method is often unreliable when calculating the beta of smaller public companies, where the stock may not trade in an efficient market. An alternative method for calculating beta is to use the published betas of guideline companies to select a beta for the subject company. Because the guideline companies have their own unique capital structures, however, the appraiser must “unlever” the guideline betas to remove the impact that the guideline company’s debt has on its beta. An unlevered beta is calculated using the following equation:
where LB is the levered beta of the guideline company; T is the tax rate of the guideline company; D is the percentage of the guideline company’s capital structure that is debt; and E is the percentage of the guideline company’s capital structure that is equity.
After selecting an appropriate unlevered beta for the subject company based on the unlevered betas of the guideline companies, the appraiser must “relever” the selected beta based on the capital structure of the subject company, using the following equation:
UB*[1 + (1 – T)*(D/E)]
where UB is the selected unlevered beta for the subject company; T is the tax rate of the subject company; D is the percentage of the subject company’s capital structure that is debt; and E is the percentage of the subject company’s capital structure that is equity. This levered beta is then applied to the equity risk premium as part of the calculation of the subject company’s cost of equity capital. This is a generally accepted method for calculating beta under the CAPM, although it is not the only method.
Last week, the Delaware Court of Chancery issued an opinion in In re Orchard Enterprises, Inc. Shareholder Litigation (Del. Ch. Aug 22, 2014) concerning an application for attorneys’ fees (we have previously posted about a significant 2012 decision in that same case by former Chancellor Strine). We found the court’s latest decision noteworthy for two reasons. First, the court reaffirmed the principle that an appraisal action brought by an individual shareholder seeking a judicial determination of the fair value of its stock as of the merger date is an entirely separate animal from a shareholder class action in which the plaintiffs allege director misconduct in connection with the price or process leading up to the transaction. Second, the court cited approvingly an upcoming law review article that highlights statistically the benefits of the appraisal process.
In 2010, The Orchard Enterprises, Inc., was acquired by its controlling shareholder for $2.05 per share in cash. Following the merger, several shareholders pursued an appraisal action, which resulted in a judicial determination that the fair value of Orchard was $4.67 per share. After the appraisal action concluded, another shareholder who had not exercised his appraisal rights brought a class action against the board for breach of fiduciary duty. The class action settled before trial. Counsel for the appraisal shareholders objected to the settlement, arguing that they should be reimbursed from the class action settlement for the fees they incurred in the appraisal action because their efforts contributed to the settlement of the class action. Vice Chancellor Laster acknowledged that the appraisal shareholders “raised the bar” for the company by demonstrating that the fair value of Orchard stock was more than double the merger consideration. However, the court ruled that appraisal counsel was not entitled to reimbursement for its fees because the appraisal action was brought on behalf of individual shareholders, not on behalf of all of Orchard’s shareholders.
In a prior post, we observed how former Chancellor Strine (now Chief Justice of the Delaware Supreme Court) repeatedly took the time to clarify the important but often overlooked distinction between fiduciary duty claims and appraisal rights actions. Vice Chancellor Laster has now followed suit in Orchard when he declined to apportion part of the class action settlement to pay the attorneys’ fees incurred by the successful appraisal petitioners. According to the Vice Chancellor, as unsecured creditors who elected not to accept the merger consideration, appraisal petitioners may have interests that conflict with shareholders pursuing breach of fiduciary duty claims after selling their shares in the merger. Moreover, unlike class plaintiffs (who frequently own only a small stake in the company), appraisal petitioners typically have significant holdings that they believe have been undervalued, so they do not need to be offered an additional incentive (such as the reimbursement of attorneys’ fees) in order for them to seek court intervention.
We also recently blogged about a forthcoming law review article by Professors Charles Korsmo and Minor Myers of Brooklyn Law School, which is expected to be published in the Washington University Law Review in 2015. In that article, the authors laud the appraisal process because it ultimately provides an efficient means for benefiting minority shareholders and reducing the cost of raising equity capital. In the new Orchard decision, Vice Chancellor Laster cited this article and expressly recognized that the effect of an appraisal rights petition “may well be a net positive” because the process “reduces agency costs when compared to traditional class actions and results in a more efficient corporation law.” This is a highly significant reaffirmation of the unique and valuable role that appraisal actions will continue to play in enhancing shareholder value.