Company value and offer price in the context of public takeovers – the fairness opinion
A fairness opinion is an independent valuation of the target company on a stand-alone basis and assists the board of directors in assessing the offer price against the background of its own expectations regarding the company’s development. The fairness opinion is therefore of central importance in the financial assessment of the offer price. It has a significant influence on whether the offer price is perceived as attractive or comparatively unattractive. In this blog we focus on the fairness opinion and its characteristics as an important element for the board of directors of the target company to assess a public takeover offer from a financial perspective.
Report of the target company’s board of directors (Art. 30 TOO)
In principle, the board of directors of the target company must comment on a public takeover offer in a report. The report must contain all information necessary to enable the recipients of the offer (i.e. particularly the shareholders) to make an informed decision.
If the recommendation of the board of directors is based, inter alia, on a financial assessment by an independent third party (which is called a «fairness opinion»), the fairness opinion becomes an integral part of the report. A fairness opinion is an independent valuation of the target company on a stand-alone basis and assists the board of directors in assessing the offer price against the background of its own expectations regarding the company’s development. This is because the objective of a fairness opinion is for a third party independent of the target company and the offeror to assess if a specific offer price is fair from a financial perspective. A binding obligation to prepare a fairness opinion only exists if fewer than two members of the board of directors are free from conflicts of interest. In practice, however, fairness opinions are regularly used.
The valuation basis, the valuation method and the parameters applied must be disclosed in the fairness opinion. Furthermore, the fairness opinion must present the valuation result in a transparent, plausible and comprehensible manner. In Swiss takeover practice, transparency rules elaborating these general statements have developed over time. In the context of the decision on Victoria-Jungfrau Collection AG in 2013, for example, it was specified that the key data for calculating the free cash flows and the terminal value must be disclosed in the context of a valuation using the discounted cash flow method.
The fairness opinion as an important decision-making element
The fairness opinion is therefore of central importance in the financial assessment of the offer price. It has a significant influence on whether the offer price is perceived as attractive or comparatively unattractive. This obviously has a significant influence on the view of the target company’s board of directors. Therefore, from the perspective of both the seller and the buyer, it is crucial to anticipate and understand the mechanisms and characteristics of a fairness opinion.
Due to the importance of the fairness opinion, in Switzerland the third party commissioned to prepare the fairness opinion must be suitably qualified and independent from the offeror, the target company and the persons acting in concert with them. This label is awarded by the Swiss Takeover Board based on a thorough examination. A review of independence is carried out on a case-by-case basis. For almost ten years now, IFBC has been suitably qualified to prepare fairness opinions for public takeover and exchange offers.
IFBC Practice Advice: The fairness opinion as an element in negotiations
The fairness opinion can be an important tool for the target company in negotiations with a potential offeror. However, in order to be able to use the fairness opinion in a targeted manner, the target company must already have visibility with regard to a potential company value prior to the actual negotiations. For this purpose, it is advisable to establish a periodically recurring valuation process based on the current management plan and applying best practices in fairness opinions.
The big picture of valuation approaches
In the context of a fairness opinion, different types of companies have to be valued using different methods. What the valuation methods have in common, however, is the fact that fairness opinions are based primarily on a fundamental valuation. The method for calculating the fundamental value ultimately depends on the valuation object. The resulting fundamental value is then usually checked for plausibility using a valuation based on comparable listed companies («trading multiples») and comparable transactions («transaction multiples»). It is important to note that a valuation is carried out using what is called the «stand-alone principle». This means that potential synergies with the offeror are not taken into account in the valuation. The valuation is carried out on a specific reference date (publication of the pre-announcement).
Classification and valuation of different valuation objects
In principle, three types of valuation objects (whereby real estate and investment companies are listed together here) are to be distinguished:
1. Industrial and service companies
The derivation of the fundamental value of industrial and service companies is usually based on the Discounted Cash Flow method («DCF method»). The DCF method is based on the principle of finance theory that the value of an asset or company is derived from the discounted, expected future Free Cash Flows («FCF»). The resulting gross operating enterprise value must be increased by the value of non-operating assets and non-operating cash, resulting in the total enterprise value. Financial liabilities, so-called «debt-like items» and non-operating liabilities must be subtracted to determine the equity value.
2. Financial services
The valuation of companies in the financial services sector is carried out from the perspective of the equity investor. This means that the valuation focuses directly on the value of the equity. This is in contrast to the valuation of industrial and service companies described above, where the value of the equity is determined indirectly by deriving the gross enterprise value using the DCF method and then subtracting debt.
There are various reasons for this, including the fact that banks generate value with the help of the liabilities (e.g. through savings deposits), but for non-financial companies the liabilities serve purely as a source of financing. Second, interest income and interest expenses form a large part of the operating business and, in contrast to non-financial companies, are key elements of success in income statements. Furthermore, regulatory requirements regarding the amount of equity capital have to be taken into account in the context of the valuation.
The model applied in this specific context is the Dividend Discount Model («DDM»), a variant of the DCF method, which discounts the expected future potential dividend payments to shareholders by the risk-adjusted cost of equity and transfers them directly into an equity value.
3. Real estate and investment companies
The derivation of the fundamental value of real estate and investment companies is usually based on the Adjusted Net Present Value method («ANAV method»). The starting point of the ANAV is a company’s Net Asset Value («NAV»). This corresponds to the value of the equity, which is the sum of the assets (i.e. the real estates or the investments) minus the liabilities (i.e. debts). To determine the NAV, all balance sheet values are checked for their upward or downward potential (market values) and adjusted accordingly where necessary. In the case of the ANAV, future company costs consisting of costs for administration, auditing, management fees, listing, etc., which are not reflected in the NAV, are also taken into account. Specifically, the present value of future company costs (discounted future expenses) is deducted from the NAV when determining the ANAV.
Frequency of the three valuation methods in practice
Table 1 shows the distribution of companies in the SPI as of 1 July 2021 compared to the distribution of fairness opinions prepared since 1 January 2018. On the one hand, the proportion of investment and real estate companies in the fairness opinions is higher because investment companies are not part of the SPI. On the other hand, as expected, the share of industrial and service companies is the largest. However, all three valuation methods are regularly used and thus have a certain significance.
Table 1: Company classification SPI as of 1.7.2021 and fairness opinions («FO») since 1.1.2018
Preview of Blog 3 of the series
While the fairness opinion may in principle be relevant for all public takeovers in Switzerland, the third blog of this series analyses the specific additional minimum price requirements for mandatory and change of control offers. These can have a significant influence the determination of the offer price.