We’ve written before about the SWS appraisal case, decided in mid 2017. After the ruling, petitioners appealed to the Delaware Supreme Court. On Wednesday, February 21, the Delaware Supreme Court held oral argument (which you can watch on this site). Part of the argument focused on the concept of size premium – a primer on which is available here – and which is being contested in the SWS appeal. For more on the SWS oral argument, see Law360 [$$$].
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.
In a prior post, we explained how the Capital Asset Pricing Model (“CAPM”) has become one of the frequently employed methods used by the Delaware Court of Chancery to calculate the cost of equity for the discount rate in a DCF analysis. In this post, we focus on one specific component of the CAPM: the equity size premium.
The equity size premium is a number added to the risk-free rate and the equity risk premium (modified by beta) to reflect additional returns on small companies. The argument is that investors may demand a higher rate of return on small companies than they do for large companies because of the increased risk associated with small company investments. The size premium supposedly quantifies the increased risk.
One method the courts have used to determine the size premium is to refer to the Ibbotson SBBI Valuation Yearbook. The Ibbotson tables, published by Morningstar, contain historical capital markets data that include, among other things, total returns and index values for stocks dating back to 1926. Morningstar recently discontinued the Ibbotson SBBI Valuation Yearbook, which means a court seeking to apply a small-size premium will have to look to other valuation materials for mergers occurring after 2013.
The Delaware Court of Chancery has used market capitalization as the benchmark for selecting a size premium. Thus, the court multiplies the amount of outstanding stock by the market price on the day prior to the merger and determines which Ibbotson decile the company falls under. The court then applies the appropriate size premium from the applicable Ibbotson table. The court may accept adjustments to the Ibbotson size premium if there is evidence of individual characteristics that distinguish the subject company from other companies within the same market capitalization decile.
Some valuation experts in appraisal cases have argued that the problem with this market capitalization approach is that it creates circularity based on the market price of the stock. The Delaware courts have acknowledged that the market price of a stock is not determinative of value in an appraisal proceeding because, among other things, the market price reflects a minority discount. The appraisal statute requires that the company be valued as a going concern, exclusive of any trading discounts. Moreover, the market price of a stock is an unreliable indicator of value when the market is inefficient (which is often the case for small companies) or when other factors affect market price. By relying on the market price to determine the size premium for the discount rate, these experts contend, the court is effectively incorporating that minority discount and inefficient market price into its valuation analysis in contravention of Section 262’s mandate that the company be valued as a going concern. An alternative approach to determine the company’s size for the purpose of ascertaining the small-size premium is to conduct an independent valuation of the company using a non-DCF method, such as a valuation based on comparable companies or precedent transactions. This alternative approach avoids the pitfalls of relying on an inefficient and discounted market price in calculating the company’s discount rate.