Further to our prior post about Delaware’s two new appraisal decisions, SWS Group was a small, struggling bank holding company that merged on January 1, 2015 into one of its own substantial creditors, Hilltop Holdings.  Stockholders of SWS received a mix of cash and Hilltop stock worth $6.92 at closing.  Vice Chancellor Glasscock rejected the sale price as an unreliable indicator of fair value and performed his own DCF analysis, setting the fair value at $6.38, a price 7.8% below the merger price.

At trial, the petitioners persuaded the court that its critiques of the sale process were valid.  However, the stockholders failed to persuade the court that SWS was on the verge of a turnaround, as the court instead determined that SWS consistently underperformed management projections and, given its structural problems, a turnaround was simply unlikely.

Problems with SWS’s Projections and Performance

As was true in PetSmart, SWS had not historically performed long-term projections, but only created annual budgets that aggregated projections from individual business sectors.  Those single-year projections were then extrapolated into three-year “strategic plans” that assumed the annual budgets would be met.  The court found, however, that SWS never met those budgets between 2011 and 2014.  Also, despite straight-line growth assumptions in the management forecasts, SWS failed to hit its targets and continued to lose money on declining revenues.  The various problems facing the company led the court to embrace the respondents’ theory that SWS would continue to face an uphill climb given its relatively small size, which prevented it from scaling its substantial regulatory, technological, and back-office costs.

Hilltop’s Influence on the Sale Process Rendered Merger Price Unreliable

Even before SWS launched its sale process, Hilltop was interested in buying the company (unbeknownst to SWS).  Also, since Hilltop had observer status on SWS’s board, it had unique access to SWS’s board meetings and management not available to others.  The court found that Hilltop’s acquisition theses were driven by synergies, as it viewed its acquisition of SWS as resulting mainly in cost savings by reduction of overhead.  A Special Committee was formed after Hilltop made its initial offer in January 2014, and the court found that even though the committee engaged legal and financial advisors, the management projections that evolved in the sale process were still overly optimistic and unrealistic about SWS’s projected growth.  Only two other bidders emerged, one of which was found not to be credible and the other continued to bid through March 2014 despite apparent pressure by Hilltop to proceed with its deal.  Finally, in response to Hilltop’s unilateral March 31, 2014 deadline, the board decided to accept its offer, which at that time was valued at $7.75, consisting of 75% Hilltop stock and 25% cash.  As of closing on January 1, 2015, the value dropped to $6.92 per share based on a reduction in Hilltop’s own stock price.

Another factor making the deal price unreliable was that Hilltop was a creditor of SWS pursuant to a Credit Agreement.  That agreement contained a covenant prohibiting SWS from undergoing a “Fundamental Change,” which was defined to include the sale of SWS.  The agreement thus conferred upon Hilltop a veto right over any competing offers, which right Hilltop refused to waive during the sale process.

Valuation Model & DCF Inputs

The court undertook its own DCF analysis, on which it relied exclusively.  The court refused to put any weight on petitioners’ comparable companies analysis, finding that the comp set diverged too much from SWS in terms of size, business lines, and performance to be meaningful.  The court held that SWS’s unique structure, size, and business model – particularly its composition of a broker-dealer business alongside its banking line – rendered the stockholders’ selected peers not truly comparable.

In performing its DCF valuation, the court used the existing three-year projection period in the management projections, rejecting the stockholders’ argument that SWS had not yet reached a “steady state” and that an additional two years was needed to normalize SWS’s financial performance.  The court found that SWS’s declining revenues in the period leading up to the merger deprived it of any basis to assume (unprecedented) straight-line growth beyond the existing three-year projection period.  In addition, the court found that the exercise of warrants three months prior to the merger pursuant to the Credit Agreement, which resulted in a change to SWS’s capital structure by cancelling debt in exchange for new shares, was part of SWS’s “operative reality” for purposes of the fair-value determination.  This ruling differed from other cases, such as BMC Software and Gearreald, where changes to the company’s balance sheet resulting from actions by the company solely in expectation of the merger – like the company paying off its debt – was not considered to be within the company’s operative reality.

As to the other DCF inputs, the court adopted the respondents’ perpetuity growth rate of 3.35%, which was the midpoint between the long-term inflation rate of 2.3%, and the long-term economic growth rate of 4.4%.  In selecting the appropriate equity risk premium, the court observed that whether to use supply-side or historical ERP should be determined on a case-by-case basis. Nevertheless, it found supply-side ERP appropriate as the “default” method in recent Delaware chancery cases, unless a party provided a compelling reason to use historical ERP.  With regard to beta, the court found fault with both side’s approach.  The respondents’ expert looked at two years of SWS weekly stock returns, which measurement period included a “merger froth” and too much volatility to be reliable.  The petitioners’ expert, in contrast, surveyed multiple betas and used a blended median; even though the court found that this approach relied on comparable companies that were not truly comparable, it nevertheless adopted this beta – despite its apparent drawbacks – as the one more closely in line with the record evidence.  Finally, to determine size premium, the court took the midpoint of both side’s decile (which was 3.46%), finding that using market capitalization is generally appropriate for public companies (the respondents’ approach), and yet SWS’s capital structure, including its substantial in-the-money warrants and the outsized influence of its major creditor, made it more like a private company and not susceptible to a market cap approach (the petitioners’ argument).


In reaching its final determination of $6.38, the court said that a sub-merger price award was not surprising here given the synergistic nature of the transaction.  Also, given the award of statutory interest, which runs from the January 1, 2015 consummation date, it appears that the petitioners will ultimately recover more than the merger price after all.


On July 8, the Delaware Court of Chancery issued its opinion in In re Appraisal of DFC Global Corp.  A financial buyer, Lone Star Fund VIII, acquired DFC Corporation in June 2014 for $9.50 per share in an all-cash deal.  Using a combination of a discounted cash flow analysis, comparable companies analysis, and the merger price, Chancellor Bouchard determined the fair value of DFC as a stand-alone entity at the time of closing to be $10.21 per share, or 7% above deal price, before adding statutory interest.

While observing “merger price in an arm’s-length transaction that was subjected to a robust market check is a strong indication of fair value,” the Court also cautioned that merger price “is reliable only when the market conditions leading to the transaction are conducive to achieving a fair price.”  Concluding that deference to merger price would be improper, the Court highlighted that “[t]he transaction here was negotiated and consummated during a period of significant company turmoil and regulatory uncertainty” arising from possible regulatory changes affecting payday lenders, such as DFC, in the countries in which they operate.  These potential regulatory changes could have had the negative effect of rendering DFC’s business not viable or the positive effect of reducing DFC’s competition in certain markets.  As a result of this uncertainty, DFC repeatedly lowered guidance throughout the sales process and potential bidders were deterred.  Indeed, Lone Star itself cited the uncertainty surrounding DFC as a reason it perceived value in acquiring the DFC.  Because of these regulatory uncertainties and their impact on management’s forecasts, the Court gave equal weight to its DCF analysis, the comparable companies analysis, and the merger price.

The Court’s opinion is also notable for its extensive discussion of the relevant beta to applySpecifically, the Court declined to rely upon Barra beta, a proprietary model designed to measure a firm’s sensitivity to changes in the industry or the market.  While not rejecting the use of Barra beta wholesale, the Court reiterated that in order to rely upon it, the expert applying the model must be able to re-create its findings and explain its predictive effectiveness, something DFC’s expert was found unable to do.  The Court also reiterated its preference for a beta that applies a measurement period of five years rather than two years unless “a fundamental change in business operations occurs.”

Finally, the Court rejected Petitioners’ expert’s use of a 3-stage DCF model.  As the Court recognized, “that the growth rate drops off somewhat sharply from the projection period to the terminal period is not ideal but not necessarily problematic.”  The Court was particularly reluctant to perform a 3-stage DCF that extrapolated from forecasts it found to be flawed given the regulatory uncertainty.  Accordingly, the Court performed a 2-stage DCF, the analysis of which is regularly cited in Owen v. Cannon, a case on which we’ve blogged on previously.

Ultimately, dissenters are receiving $10.21 per share, along with interest accruing from the June 13, 2014, closing at the statutory rate of 5% over the Federal Reserve discount rate, compounded quarterly.  A back-of-the-envelope calculation suggests that, as of this posting, the appraisal award thus rises to approximately $11.50 total, or approximately 21% over the merger price, once interest is factored in.

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.

Calculating Beta

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.