DE Chancery admits that size premium debate is still ‘evolving’

BVWireIssue #119-5
August 29, 2012

After last week’s item on the new statutory appraisal decision by the Delaware Court of Chancery in In re Orchard Enterprises, we received thoughtful responses related to the court’s findings on the company-specific risk premium (CSRP) and the size premium adjustment:

  • “The Delaware Chancery's decision with respect to the adjustment of the size premium when using Ibbotson's supply-side ERP proves only two things,” writes James Lurie (CapVal-American Business Appraisers). “First, judges and court decisions are often incorrect. Second, appraisers should stick to their guns and fully support their methods in order to enable judges and courts to adjust their thinking. The primary example of this was [Shannon] Pratt himself on the issue of taxes on built-in gains.”
  • “Maybe somewhat surprising to some people, I would not have added a company-specific risk premium to the discount rate, either,” says Pete Butler (Valtrend). For one, the company had been publicly traded before the going-private merger, and two, the institutional buyer (the controlling private equity group) was presumably well-diversified. That said, “I have never added a CSRP to my discount rates to reflect (as the court would have it) ‘that the company has risk factors that have not already been captured by the equity risk premium as modified by beta and (if applicable) the small company size premium.’ Rather, I have added a CSRP to my discount to price it relative to the private markets, in accordance with financial theory [which says such risk] cannot be easily diversified away.”

These comments beg further questions and perhaps a fuller excerpt from the court’s opinion:

  • What, precisely, did the court get wrong in its decision not to adjust the size premium in this case? “By adding a hefty 6.3% premium into the CAPM formula for size, Orchard is treated fairly, in my view,” V.C. Strine wrote, “even though I acknowledge that academic and practitioner thinking [in] this area seems to be in a period of active evolution.” What circumstances might convince the court to adjust the size premium in a future case?
  • Based on the court’s continued reluctance to adopt a CSRP in any case, what’s the future of this input in either a modified CAPM or the build-up method? And does the court’s clear rejection of the BUM spell the death of this method for deriving the discount rate—at least in Delaware?

It’s our latest free download. To help you answer these questions and obtain a complete overview of the court’s reasoning, we’ve just posted In re: Appraisal of The Orchard Enterprises, Inc. as the latest resource on our free downloads page. Read it and please do send any further comments to the editor.

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