HOT TOPICS IN THE VALUATION OF CONTINGENT CONSIDERATION

Transcription

1 HOT TOPICS IN THE VALUATION OF CONTINGENT CONSIDERATION Lynne J. Weber, Ph.D. Duff & Phelps, LLC Gary J. Raichart Duff & Phelps, LLC This presentation is issued for informational purposes only. It is distributed with the understanding that the publisher is not rendering legal, accounting, tax or other consulting advice and assumes no liability in connection with its use.

2 Agenda Background Info on Contingent Consideration Overview of Contingent Consideration Valuation Implementation Issues Update on TAF Voluntary Guidance on Valuation of Contingent Consideration What s New? Answers to Comment Letter Questions Q&A This presentation captures current thinking regarding the valuation of contingent consideration and estimating the market price of risk, however: Additional guidance may be provided through issuances of new Accounting Standards Updates and new insights may be provided by the Appraisal Foundation working group Practice and our thinking will evolve over time As a result, any positions taken here may be updated in the future

3 Definition of contingent consideration (CC) Contingent consideration is defined as: An obligation of the acquirer to transfer additional assets or equity interests to the former owners of an acquiree as part of the exchange for control of the acquiree if specified future events occur or conditions are met. OR The right of the acquirer to the return of previously transferred consideration if specified conditions are met. 1 Initial measurement of contingent consideration under ASC Topic 805 and IFRS 3R: Recognize at acquisition-date Fair Value as part of the consideration transferred. 2 Fair Value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date ASC Master Glossary, IFRS 3R Appendix A 2. ASC , IFRS 3R:39 3. ASC Master Glossary, IFRS 13:9

4 25-28% of private deals over last 5 years have earnouts 19% Private Deals with Earnouts 29% 38% 25% 26% 28% More common in life sciences deals: ~70% of private company deals Performance Metrics for Earnouts Revenue* Earnings/EBITDA* Sources: American Bar Association, Private Target Mergers & Acquisitions Deal Points Study (US, Canada, EU), 2017; SRS Acquiom Private Deal Terms Study (Worldwide), 2017 Other Indeterminable 18% 33% 37% 29% 30% 35% 30% 32% 32% 37% 35% 30% 26% 26% 26% 9% 5% 11% 13% 11% 12% 27% 32% 29% * A combo of revenue & earnings also appeared in 0-5% of deals

5 Earnouts in non-life sciences private deals Median earnout potential: ¼ to ½ of closing payment Earnout length: typically 1-3 yrs. 60% 50% 40% 46% 53% 40% 1 year or less 1 to 2 years 29% 26% 18% 34% 50% 47% 30% 20% 33% 25% 23% >2 to 3 years >3 to 4 years 5% 7% 9% 0% 20% 23% % >4 to 5 years 2% 5% 21% 0% >5 years 2% 0% SRS Acquiom Private Deal Terms Study 2017, 2018

6 Agenda Background Info on Contingent Consideration Overview of Contingent Consideration Valuation Implementation Issues Update on TAF Voluntary Guidance on Valuation of Contingent Consideration What s New? Answers to Comment Letter Questions Q&A

7 Overview of CC Valuation: Common CC structures Earnout and clawback payoffs are: Contingent on, and often complex functions of, uncertain future events Typically option-like (when financial metrics are involved)

8 Probability Overview of CC Valuation: A probabilistic model is warranted Scenario based models (SBM) typically use a discrete distribution (often scenarios and their probabilities). Recommended when: Metric risk is diversifiable, e.g. R&D milestone OR Payoff structure is linear Option pricing models (OPM) typically use a continuous distribution (often lognormal, requiring expected case forecast and a volatility) and a risk-neutral framework. Recommended when: Metric risk is non-diversifiable and payoff structure s is nonlinear (thresholds, caps, tiers, carry-forwards, etc.) Scenarios for metric Metric distribution

9 Overview of CC Valuation: Discount rate Discount Rate / Risk Adjustment: Metric Risk Payoff Structure Risk Time Value of Money SBM Required Metric Risk Premium (RMRP) Assessment (challenging for nonlinear payoff structures associated with non-diversifiable risks) Risk-free rate over relevant time horizon until payment OPM Required Metric Risk Premium (RMRP) Built into OPM s risk-neutral framework Risk-free rate over relevant time horizon until payment Counterparty Credit Risk Obligor s credit spread Obligor s credit spread

10 OPM: Discounting for metric risk before applying the CC structure Example: an earnout payment of 100 if EBITDA exceeds 2,000 Real World Undiscounted Distribution Risk-Neutral Distribution

11 Agenda Background Info on Contingent Consideration Overview of Contingent Consideration Valuation Implementation Issues Update on TAF Voluntary Guidance on Valuation of Contingent Consideration What s New? Answers to Comment Letter Questions Q&A

12 Implementation: Key inputs There are 4 primary inputs for each of SBM and OPM: 1. For OPM: Expected case (mean) forecast for the metric Volatility in projected metric growth rate 2. For SBM: Expected case forecast (or scenarios with probabilities, e.g. for technical milestones) Impact of payoff structure on the discount rate 3. Discount rate for the metric (i.e., required metric risk premium or RMRP ) 4. Discount rate for the payment: risk-free rate (RFR) + counterparty credit spread, over the time horizon until payment

13 Implementation: Expected case forecast Start with management s expected case forecast for the earnout metric (e.g., revenue) Expected case = the probability-weighted mean, not the most likely case Incorporate all synergies including buyer-specific synergies included in the earnout calculation definition For OPM, the expected case growth rate must be adjusted to account for the systematic risk associated with the earnout metric.

14 Implementation of OPM and SBM: RMRP and adjusting for leverage the risk of the cash flows for the target s enterprise RMRP (Revenue) Operational and financial leverage magnify a company s risk RMRP (EBITDA) Consistent, not generally equal RMRP (Net Income) the risk of the earnout metric RMRP (Cash Flows to the Business) Risk Operational leverage (Fixed costs) Financial leverage (Debt interest) plus leverage due to nonlinearities in T, D, A Leverage due to nonlinearities in D, A, CapEx, WC

15 Estimating the RMRP: Top-Down method vs. Bottom-Up method Top-Down Bottom-Up IRR Implied Excess Required Premium Long-term Risk Free Rate Additional Premiums Unadjusted WACC* Long-term Risk Free Rate Adj. for Leverage(s) Adjusted Additional Premiums Adj. for Leverage(s) Beta Metric Market Risk Premium Adj. for Term Metric Term RFR Metric s Risk Adjusting Discount Rate Required Metric Risk Premium Metric Term RFR Adjusted Additional Premiums Beta Metric Market Risk Premium Metric Term RFR Adj. for Risk not captured by Beta Metric Beta Metric Market Risk Premium Metric Term RFR * Unadjusted WACC is the weighted average cost of equity and cost of debt excluding any additional premiums

16 Counterparty credit risk & RFR: match the duration until payment Time value of money: the RFR to match the duration E.g., if the earnout is expected to be paid in 1.25 years, use a short-term risk free rate for that period Counterparty credit risk: usually the spread between the obligor s cost of debt and RFR that matches the duration of the earnout payment timing, taking into account: Mitigation of non-payment risk via e.g. use of an escrow account Seniority of the earnout claim in the obligor s capital structure (most earnouts are subordinate obligations) Correlation between the amount of CC paid and the obligor s ability to pay

17 Agenda Background Info on Contingent Consideration Overview of Contingent Consideration Valuation Implementation Issues Update on TAF Voluntary Guidance on Valuation of Contingent Consideration What s New? Answers to Comment Letter Questions Q&A

18 The Appraisal Foundation (TAF) Working Group Status Update To address the complexity and diversity in practice of valuing CC, TAF formed a Working Group on Valuation of Contingent Consideration. Representatives from CliftonLarsonAllen, Duff & Phelps, Empire, EY, KPMG, and PwC, with Appraisal Practices Board Liaisons from Deloitte and FRA. Exposure Draft released February 28, 2017 Comment Period ended April 28, different comment letters from 13 different organizations/individuals Over 70 different substantive issues/topics/questions After considering the comments, an updated version is nearing release More clarity, more detail, but the substantive, high-level guidance is unchanged

19 What s New: Clarity via comparison to business valuation Projections Level of detail Synergies Discount Rate Business Valuation Typically uses expected cash flows; does not require assumptions about the probability distribution around the mean Includes market participant synergies, excludes buyer-specific synergies Earnout Valuation Unless linear structure, requires assumptions about the probability distribution for future earnout metric outcomes Includes all synergies relevant to the payoff calculation RFR Long-term RFR RFR based on time until the earnout payment(s) are made Counterparty credit risk Risk premium Impact of earnout structure Not relevant Risk premium for long-term free cash flows (i.e., WACC or IRR less RFR) Not relevant Typically, obligor s credit spread for subordinated debt in the scenarios in which, and over the timeframe until, the earnout payment(s) are made Required Metric Risk Premium for the earnout metric For a metric with non-diversifiable risk, nonlinear payoff structures impact the effective discount rate

20 What s New: A discussion of who are the market participants (MP) Who should be considered the MP when valuing contingent consideration? NOT the MP for other items requiring fair value determinations in a business combination MP = acquirer in a hypothetic transaction involving the transfer of a contingent consideration liability or asset on a standalone basis Could be a private equity firm, hedge fund, other investor in future CC payments A MP would consider the CC value separate from the related business Therefore will consider the impact of buyer-linked characteristics on CC cash flow

21 What s New: More discussion on RMRP for earnings-based earnouts The RMRP for earnings-based metrics can often be estimated as follows: WACC LTRFR RMRP EBITDA RMRP EBIT Where: LTRFR = long-term risk-free rate However, the valuation specialist should assess whether this approximation is reasonable. Some of the circumstances in which such an approximation might not be reasonable are: Substantial cash flow adjustments due to depreciation, amortization, CapEx, etc. Significant differences in risk between short-term and long-term earnings Significant differences in risk arising from inclusion/exclusion of synergies Taxes not linearly related to pre-tax earnings or significant tax shield differences

22 What s New: Methods for de-levering RMRP for operational leverage The ED discussed 3 methods for de-levering an earnings beta to get a revenue beta: Fixed Costs vs. Assets Method Volatility-Based Method Modified Harris-Pringle Method Operating = Unlevered / [1 + Fixed Costs/Variable Costs] Modified Harris-Pringle is not recommended for de-levering an earnings RMRP for operating leverage (to get to a RMRP for revenue), because: Doesn t relate either fixed or variable costs to revenue or earnings Gives the same result whether total costs are 1% of revenue or 100% of revenue... it may not result, therefore, in a reasonable estimate of a revenue RMRP.

23 What s New: Discussion of pros/cons of volatility estimation methods There are numerous methods for estimating metric volatility, including: De-leveraging Equity Volatility Method: De-lever historical equity volatility Historical Metric Variability Method: Use historical variability in metric growth rate Management Assessment Method: Use assessments of alternative outcomes This list is not meant to be exhaustive.

24 De-leveraging Equity Volatility Method De-lever annualized equity volatility (subject company and/or comparables) Historical equity volatility and/or Implied volatility from traded options Use a half-period of volatility Issues: Only a proxy for volatility relative to management s forecast Includes the volatility in required investor return for equity investments (may overestimate volatility for short-term earnouts) Equity Volatility Financial Leverage EBIT Volatility Operational Leverage Revenue Volatility

25 Historical Metric Volatility Method Use historical volatility in metric growth (subject company or comparables) Use year-on-year quarterly growth (so seasonality does not artificially impact the volatility estimate) Use a full period of volatility Issues: Only a proxy for volatility relative to management s forecast Might not provide a reasonable estimate for a young or rapidly evolving business Excludes volatility in required investor return (may underestimate volatility)

26 Revenue (Millions) Management Assessment Metric Volatility Method Management assesses multiple cases Use to calculate an implied metric volatility Use debiasing techniques to avoid conscious and unconscious biases Use a full period of volatility Issues: Excludes volatility in required investor return (may underestimate volatility) $600 $500 $400 $300 $200 $100 $0 Base Case, High and Low Scenarios

27 What s New: Discussion of assessment debiasing techniques Well-known assessment biases include: Anchoring on recent results or prior projection Overconfidence Hidden assumptions Debiasing techniques include: Counteranchors, counterexamples, contemplation of extreme scenarios Assessing multiple scenarios Conducting pre-mortems Taking an outside perspective Crosschecks Decomposition

28 What s New: Volatility estimate should be consistent with RMRP Potential adjustments to the estimated metric volatility for: Additional risk premiums, e.g., a size or company-specific premium Differences in time horizon (earnouts are often short-term) Differences with respect to inclusion of volatility in returns required by investors Cross-checks of the estimated volatility, to test for reasonableness as compared with: Management s projected variability (if relying on historical data or data from comparable companies) Volatility of comparables (if using management assessments) The estimated RMRP The rationale for the earnout structure

29 What s New: Techniques for adjusting volatility for size premiums Techniques to address size differences between the subject business and comparable companies used to estimate metric volatility include (but are not limited to): 1. Select a volatility at a percentile of the range of comparable companies based on the size of the earnout-relevant business relative to the size of the comparable companies 2. Adjust the volatility estimate for each comparable company based on the following ratio: (the RMRP including a size premium for the subject company) (the RMRP replacing the size premium with that for the comparable company) 3. Adjust the volatility estimate for each comparable company by the following ratio: (average volatility of companies in the size category for the earnout-relevant business) (average volatility of companies in the size category for the comparable company) Adjustments might also be considered for company-specific or country risk premiums

30 What s New: More discussion of correlation & credit risk Consider the counterparty credit risk associated with making the future payments if and when they become payable In rare cases, the earnout payment obligation affects the obligor s creditworthiness E.g., when the obligor is not significantly larger than the acquired company and when the contingent payment is a large enough multiple of revenues or EBITDA For a clawback, the downside scenarios associated with payment might be correlated with financial stress on the obligor (unless credit risk is mitigated, e.g. via escrow) In such cases, creditworthiness can be modeled within specific scenarios of future outcomes

31 What s New: Discussion of multi-currency payoff structures For earnouts that span multiple currencies Can conduct the analysis in one currency, then use spot rates to convert the fair value to another currency Can use forward foreign exchange rates to change the currency of a metric forecast Features that have a nonlinear relationship with the earnout payment (thresholds, caps, tiers, etc.) typically can t be easily converted to another currency o If the features are denominated in a single currency, use that currency for the analysis o If the multiple-currency features are not interdependent, disaggregate and analyze separately o Otherwise, might require the use of a stochastic foreign exchange rate model

32 What s New: More discussion of academic literature support Academic literature supporting use of OPM for non-traded metrics includes Literature on option pricing theory, starting in 1973 Literature on real options, with textbooks starting in the 1990s Insurance industry literature on pricing risks, including the pricing of contingent payoffs where the underlying asset or liability is not traded Literature specific to valuing earnouts, thin until recently (first reference in the guide is from 2005) Literature on estimating asset betas, revenue betas, short vs. long-term betas

33 Agenda Background Info on Contingent Consideration Overview of Contingent Consideration Valuation Implementation Issues Update on TAF Voluntary Guidance on Valuation of Contingent Consideration What s New? Answers to Comment Letter Questions Q&A

34 Comment Letter Questions: When to use OPM Do you recommend OPM for valuation of ALL earnouts based on financial metrics in which there is a threshold, tier, cap, carry-forward, etc.? Essentially yes Exception: if a de minimis chance of the threshold, cap, or tiers impacting the value, then the form becomes effectively linear Note that this can happen with the passage of time, for update valuations Exception: materiality Does this apply in other fair value contexts, e.g. IFRS? ASC 946? Yes

35 Comment Letter Questions: Practical expedient Is there a practical expedient to use in lieu of OPM, for earnouts with nonlinear structures on financial metrics (for initial valuation or updates)? Essentially No Even for updates, unless changes are not material, there is no generic practical expedient SBM is not a practical expedient Would need to consider simultaneously the implications of the structure, metric, volatility, and positioning of the mean relative to the payoff threshold Example: Varying volatility and moneyness while keeping the payoff structure the same, the discount rate ranges from about 30% to well over 100% Example: Varying only the payoff structure (same metric, volatility, relative positioning of mean), the implied discount rate varies from 10% to 40% for the earnouts to -28% for the clawback

36 Comment Letter Questions: Discount rate to use with SBM What discount rate to use when applying SBM to value a linear earnout? Often not the WACC or IRR Choose a discount rate appropriate to the underlying metric E.g., risk for revenue is not the same as for EBITDA, due to operational leverage Include the relevant portion of any size, company-specific, etc. premiums RFR + counterparty credit risk spread over the earnout-relevant timeframe

37 Comment Letter Questions: What synergies to include What synergies should be included when valuing the earnout? Based on the definition of the metric in the purchase agreement Include any synergies in the definition of the metric, including buyer-specific participant synergies if they are relevant to computation of the payoff Exclude any synergies not in the definition of the metric, even market participant synergies if they are not relevant to the computation of the payoff Differences in synergies can cause differences in risk (and hence, the RMRP)

38 Comment Letter Questions: Starting from the IRR/WACC Is the IRR/WACC a good starting point for the discount rate estimation? Yes if using a top-down method, provided the business cash flow projections are a good representation of expected case (mean) projections If not expected case (mean), inaccuracies or inconsistencies can arise If the IRR and WACC differ significantly, consider whether there is an overpayment or underpayment situation Alternatively, can use bottom-up (relationship to WACC/IRR is a cross-check)

39 Comment Letter Questions: Use a pre-tax or a post-tax discount rate, for the RMRP for pre-tax earnout metrics? Generally use post-tax discount rates for the RMRP Typically taxes do not significantly impact risk (linearly related to pre-tax earnings) Exceptions can occur when the relationship between pre-tax and post-tax earnings is nonlinear over the earnout-relevant time horizon, e.g.: (1) A significant chance of pre-tax earnings being negative (2) Significant net operating losses or tax credits (3) A large, fixed tax payment is anticipated (4) Pre-tax and post-tax cash flows differ due to, for instance, the inclusion or exclusion of large amounts of depreciation or amortization

40 Other Comment Letter Questions Do the recommendations require the use of CAPM? No. The same principles apply to other models for estimating systematic risk, including CAPM with adjustments (e.g., additional premia), the Fama-French Five-Factor Model, etc. Shouldn t the estimated volatility for metric growth be the volatility relative to management s forecast of that metric? Yes What if a lognormal isn t a good approximation, because EBITDA can go negative? A typical profit-based earnout is generally only paid when profits are substantially positive making it most important to correctly capture the likelihood of upside outcomes If <0 is important, try modeling with e.g. revenues (estimate profits and payoffs accordingly), or can use more complex models (e.g., Wang transform) Sometimes OPM isn t used for valuing assets/liabilities with payment structures involving thresholds or caps. Is there a potential for inconsistency? Yes

41 Agenda Background Info on Contingent Consideration Overview of Contingent Consideration Valuation Implementation Issues Update on TAF Voluntary Guidance on Valuation of Contingent Consideration What s New? Answers to Comment Letter Questions Q&A