Untested beta calculation KOs expert’s credibility and fair value conclusion

BVWireIssue #209-3
February 19, 2020

shareholder dissent/oppression
beta, weighted average cost of capital (WACC), closely held corporation, statutory appraisal, discounted cash flow analysis, projections, cost of equity, guideline companies, cost of debt

In a statutory appraisal case with several twists, the Delaware Court of Chancery recently agreed with the parties’ experts that a discounted cash flow analysis was the only way to determine fair value while rejecting, unequivocally, the company expert’s novel approach to calculating beta. The expert’s willingness “to go out on a limb to support a forensic valuation opinion” raised serious questions about the admissibility of his testimony under Daubert and about his entire valuation analysis, the court noted.

This case involved a privately held company that provided process outsourcing and financial technology services to various industries. The petitioners held a minority stake in the company, and several other investors owned the remaining interests. Top executives of the company pursued a number of transactions that culminated in a business combination by which the subject company merged into another company and became a publicly traded company.

Disavowing own expert: Notwithstanding recent case law from the Delaware Supreme Court that embraced the use of market indicators to determine fair value, the court and the parties agreed that here there was no reliable market evidence because the company’s stock was not publicly traded and company managers made no effort to undertake a proper sales process. Accordingly, the parties’ experts relied on “traditional valuation methodologies,” i.e., the DCF, or a variation of it. The court approved of this approach.

But it noted that the experts’ value conclusions were “solar systems” apart. Disagreements between party experts were nothing new, the court observed. What added a twist to this proceeding was that the company “disagrees with its own expert,” the court said. The company claimed its expert’s fair value determination was too high, relying on the testimony of witnesses who were impeached. The court promptly dismissed the company’s value conclusion.

As to the experts’ divergent inputs, the court noted the “most consequential point of disagreement” was over how to calculate the company’s equity beta. The petitioners’ expert, using a generally accepted method, calculated beta indirectly, based on 19 publicly traded comparable companies, the court emphasized. In contrast, the company’s expert said there were no comparable companies and that he could not use “indirect or regression-based betas.” Therefore, he calculated beta “directly by looking to market evidence” of the company’s debt. The court observed the debt was not publicly traded; these were private loans that traded only by appointment. Debt pricing services had observed incorrect and incomplete information as to the company’s debt.

The expert admitted he came up with this approach for this case. He had not used this method before, nor had he seen this method used before, but hoped it would “catch on” in the future.

The court, with disapprobation, said the company’s expert was “[u]sing the courtroom as an incubator for his experiment.” In a footnote, the court added that it was “ill-equipped to assess the merits of the theoretical debate” in which the parties’ experts engaged as to the implications of this novel theory for beta approximation, “much less who will ultimately prevail should the debate continue in the academy where it belongs.” The crux was that the method was new, as the company’s expert admitted, and the petitioners’ expert’s method was “tried and tested.” “As lay fact finder, I place my trust in the generally accepted methodology,” Vice Chancellor Slights said.

The court concluded the petitioner expert’s valuation was “credible and reasonable” and adopted it “in toto,” with a minor adjustment to the expert’s size premium. The petitioner expert’s fair value was $5,100 per share, the company expert’s fair value was $2,800 per share, and the court’s fair value was $4,600 per share.

Takeaways: (1) The DCF has a role to play in Delaware appraisal proceedings featuring privately held companies; and (2) there are venues for experts to introduce and test novel valuation approaches, but the courtroom is not one of them.

A digest of Manichean Capital, LLC v. SourceHOV Holdings, Inc., 2020 Del. Ch. LEXIS 38, 2020 WL 496606 (Jan. 30, 2020), and the court’s opinion, will be available soon at BVLaw.

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