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an opinion on fairness opinions

2 Nov

Several months ago, I reviewed the NYSE Euronext’s proposed merger with Deutsche Borse.  At nearly 900 pages, it was a huge document with loads of information: the agreement and exchange offer, regulatory issues, standalone financials, pro-formas, management discussion, risk factors, background of the merger (a personal favorite), projections of synergies, opinions about the merger from investment banks, etc..  Each time I’ve reviewed merger documents trying to find holes and glean new insights, I continue to be amazed that banks are still paid so much for so-called ‘fairness opinions’.  [This post is a bit longer than usual, but contains several citations with our emphasis that don’t require word-for-word reading.]

Let’s face it, executives are going to push a deal through whether or not it’s good.  With Excel spreadsheets it’s too easy to ‘click and drag’ indefinite predictions of a rosy future.  Valuation models are ‘garbage in, garbage out’, and many large mergers turn out to be just that, garbage, at least for shareholders (executives tend to fare better, owing to change-in-control provisions).  So, predicted ‘synergies’, mostly cost-savings, can really be about anything executives say they are.  Who am I to question their predictions?  And fairness opinions are there to serve the C.Y.A. function for boards of directors.

A fairness opinion is essentially a stamp of approval from an investment bank about a transaction.  In official terms, “A fairness opinion addresses, from a financial point of view, the fairness of the consideration in a transaction.  Fairness opinions are routinely used by directors of companies in connection with a change in control transaction, such as a merger or sale or purchase of assets, to satisfy their fiduciary duties to act with due care and in an informed manner.”

To us, “to satisfy their fiduciary duties” essentially means to pass the buck when a merger doesn’t work as projected.  According to professor Robert Holthausen (@Wharton), more than half of mergers fail and “one recent study found that 83% of all merger fail to create value and half actually destroy value.”  Yet, 80% of board members involved in acquisitions thought theirs had created value for the company.  So, I know out of the gate that regardless of what the opinion says it has about a coin’s flip chance of being accurate.  Yet, bankers are paid millions to prepare these 3-4 page documents with a clear financial incentive to help engender that outcome.

The below excerpt increases the length of the post, but it need not be read in its entirety.  I’ve bolded the main points.

The full text of Perella Weinberg’s written opinion, dated February 15, 2011, which sets forth, among other things, the assumptions made, procedures followed, matters considered and qualifications and limitations on the review undertaken by Perella Weinberg, is attached as Annex B to this document. Holders of NYSE Euronext shares are urged to read Perella Weinberg’s opinion carefully and in its entirety. The opinion does not address NYSE Euronext’s underlying business decision to enter into the combination or the relative merits of the combination as compared with any other strategic alternative that may have been available to NYSE Euronext. The opinion does not constitute a recommendation to any holder of NYSE Euronext shares or Deutsche Börse shares as to how such holders should vote or otherwise act with respect to the combination or any other matter and does not in any manner address the prices at which NYSE Euronext shares, Holdco shares or Deutsche Börse shares will trade at any time. In addition, Perella Weinberg expressed no opinion as to the fairness of the combination to, or any consideration to, the holders of any other class of securities, creditors or other constituencies of NYSE Euronext. [Isn’t this a fairness opinion?]  Perella Weinberg provided its opinion for the information and assistance of the NYSE Euronext board of directors in connection with, and for the purposes of its evaluation of, the combination. This summary is qualified in its entirety by reference to the full text of the opinion. Perella Weinberg’s business address is 767 Fifth Avenue, New York, NY 10153, United States of America. Perella Weinberg has given its consent to the use of its opinion letter dated February 15, 2011 to the Board of Directors of NYSE Euronext, in the form and content as included in this document, as this document stands, at the time of publication.  In giving such consent, Perella Weinberg does not admit that it comes within the category of persons whose consent is required under Section 7 of the US Securities Act of 1933, as amended, or the rules and regulations of the US Securities and Exchange Commission thereunder, nor does Perella Weinberg thereby admit that it is an expert with respect to any part of the Registration Statement on Form F-4 of Alpha Beta Netherlands Holding N.V. filed with the Securities and Exchange Commission, which includes the proxy statement/prospectus, within the meaning of the term “expert” as used in the Securities Act of 1933, as amended, or the rules and regulations of the Securities and Exchange Commission thereunder.

So, hopefully it’s apparent that the opinion really isn’t anything but an expensive formality.

Here are some more “outs” from Deutsche Bank’s opinion (emphasis ours).

DBSI prepared these analyses for purposes of providing its opinion to the Deutsche Börse management and supervisory boards as to the fairness to holders of Deutsche Börse shares from a financial point of view of the Deutsche Börse exchange ratio. These analyses do not purport to be appraisals nor do they necessarily reflect the prices at which businesses or securities actually may be sold. Analyses based upon forecasts of future results, including the broker projections and estimates of the synergies, are not necessarily indicative of actual future results, which may be significantly more or less favorable than suggested by these analyses. Because these analyses are inherently subject to uncertainty, being based upon numerous factors or events beyond the control of the parties or their respective advisors, none of Deutsche Börse, NYSE Euronext, DBSI or any other person assumes responsibility if future results are materially different from those forecast.

Each opinion issued contains similar language.

Don’t forget the indemnification language.  “Deutsche Borse also agreed…to indemnify Deutsche Bank and its affiliates against certain liabilities, in connection with this engagement.”  This language applies more or less equally to each company issuing its opinions and advice.  Bankers are relying on management’s internal projects and representations, and this becomes another out through which they can’t be held liable for future results.

I could go on and on with examples, but won’t belabor the point beyond those illustrated above.

In the NYSE case, Pirella Weinberg was paid $5 million upon the public announcement of the agreement of the combination and is to be paid $22.5 million upon the completion. Deutsche Bank will be paid €14 million ($20.5 million) contingent upon completion of the combination — or a max of €2.4 million ($3.5 million) if not completed, and JP Morgan will be paid $10 million, “a substantial portion of which will become payable only if the proposed exchange offer and merger are consummated.”  Is it really worth more than $50 million for some financial analysis and a rubber stamp?

In summary:

  • The incentive structure is misaligned:
  • Indemnification from the company makes banks’ liability negligible, absent some demonstrable lack of due diligence or fraud
  • Banks are paid mostly through contingent fees (if the deal is consummated)
  • There are numerous “outs”:
    • Like auditors, the representation letter signed by management gives opinion-writers an “out”, i.e., “We relied on management’s representations and do not independently verify…”
    • Buckets of “we do not do X, Y, Z” and “…the opinion is not…” statements
    •  “The future is inherently unpredictable”

All of that said, there is a lot of work involved and some fairly sophisticated modeling is required to back up the opinion.  Yet they simply should not cost $10-20 million on both sides of the transaction.  My company, Sagacious, Inc., offers fairness opinions and is working on for those who desire a fairness opinion but prefer it delivered on a non-contingent, fixed fee basis.  We offer experienced analysis and will work one-on-one with boards of directors and managements to offer an informed, measured opinion.  We’ll determine whether the deal is fair from a financial point of view for a lower, fixed price sans conflicts of interest.  Meanwhile, the shareholders will continue to pay (way too much) for such opinions.

Disclosure: No positions in any of the companies mentioned.


Private Equity’s Newest Bet

2 Oct

Harrah’s Entertainment (HET) shares got a big boost today, up about 14%, having received an $81/share buyout proposal from two private-equity firms. That price values Harrah’s at 20 times forward earnings and about 10 times operating cash flow. At market close, the shares were still trading about 7% under the deal price. Does the market not think this deal will consummate?

It’s a cash deal, which means that the newly private firm will be saddled with large amounts of new debt (Harrah’s market cap at the deal price is $15 billion) while assuming over $10 billion of existing debt. Interest expense currently totals around 25% of EBITDA. My primary worry in the near-term is that adding significantly to its debt load would limit its flexibility during a downturn.

True, at this point Harrah’s generates a healthy amount of operating cash flow that could service additional debt, but in recent years that cash flow has been used to fund considerable capital expenditures. Could more debt meaningfully restrict their ability, for instance, to develop their properties on the Vegas Strip to better compete with MGM’s upcoming City Center?

Typically, these private equity deals work out the best when a firm can slash costs, wringing out extra cash to pay down the new debt. Yet this could be detrimental to Harrah’s, where capital spending is vital not only to maintain its growth track, but also to keep its casinos relevant and its competitive position in place.

It’ll be interesting to watch. With insiders owning over 4% of the shares, shareholders can bet the board has their interests in mind. Feel like a gamble? Go long Harrah’s shares and bet the deal goes through.

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