BVR Logo 5 October 2021 | Issue 31-1

BVWire—UK is a free service from BVR focusing on the business valuation profession in the United Kingdom. We offer news and perspectives from valuation thought leaders, the High Courts, HMRC, the standard-setters, ICAEW, RICS, IVSC, and more.

Please be in touch with your perspectives, news, and ideas—and pass this issue along to colleagues (complimentary sign-up instructions are here).

HMRC closes family investment company review unit

HMRC closed down their “secret” specialist unit that was set up to review family investment companies (FICs) last month, concluding that they found no evidence linking the use of FICs with inheritance tax (IHT) noncompliance. The unit began its investigations in 2019.

The use of FICs accelerated since 2006 as an alternative to trusts (the tax rule change then enabled a 20% upfront IHT charge for the traditional family trust approach, making them instantly less popular). Similarly, FICs allow the transfer of wealth to other family generations without full transfer of control during the owners’ lifetimes—but without the upfront cost. A dedicated team looking for excessive tax avoidance will no longer deal with FICs, which will be treated as “business as usual.” In other words, business valuation experts can expect to see more wealthy clients using FICs in the foreseeable future for succession planning and wealth-holding structures.

New model helps valuers understand how unrecognised intangibles skew future performance measures

Businesses in sectors where intangibles dominate tend to have higher observed values and returns—but this may have more to do with the accounting than underlying economics. When these higher reported returns on invested capital (and forward-looking expected incremental ROIC) are used in a DCF or in a valuation multiple model input, valuation experts “need to apply a higher figure … and one that is structurally above the cost of capital,” so argues The Footnote Analyst in their latest (21 September) article “Missing Intangible Assets Distorts Return on Capital.” The new article also offers an excellent (and free) interactive model to help financial experts demonstrate how capitalising intangible investment would affect target company profit and returns.

Small, growing companies without recognized intangible assets (typical of those valued by business valuers) generally see an understatement of profit and, of course, a reduction of invested capital on the balance sheet, both of which distort ratio analysis versus larger comparable companies. This forward-looking return indicator also skews DCF analyses.

The authors support current intangibles accounting while recognising that “estimates of internal intangible asset ‘investment’ and the useful life and recoverability of the resulting assets are all difficult” and open to manipulation by management. “We believe that investors need more information about the differing nature of operating expenses, and the extent to which these are ‘future-oriented’ and result in value creation and therefore intangible assets. Even if intangible asset investment is not capitalised in the primary financial statements there should, at the minimum, be better information provided in the footnotes.”

ESG is not an investment strategy and can lead to business valuation errors, Damodaran argues

BVWire—UK is not the only source questioning whether ESG rankings have a role in valuation theory or practice. “I believe ESG is not just a mistake that will cost companies and investors money, while making the world worse off. It creates more harm than good for society,” Aswath Damodaran, professor of finance at Stern School of Business at New York University, wrote on his blog “Musings on Markets” late last month.

As two small examples of the expensive institutionalisation of compliance and reporting programmes based on ESG, the UK Competition and Markets Authority (CMA) released its new “greenwashing” codes last week. Meanwhile, the Financial Reporting Council (FRC) published FAQs on 23 September about how to set additional sustainability standards.

There’s a further analysis of this problem in an article in the new October issue of Business Valuation Update titled “Warning to Business Valuers Looking to Use New ESG Ratings.”

Damodaran’s concern echoes those expressed in “Unhedged,” the FT blog written by Robert Armstrong, who is even more concerned that ESG ratings are counterproductive for both business valuers and investors.

When I say that environmental, social and governance investing does the world harm, people assume I’m exaggerating for effect; that what I write is clickbait. Nope. I’m sure the ESG investing industrial complex is well intentioned, but I am equally confident that the world would be a better place without it. To use Tariq Fancy’s analogy, the industry is selling wheatgrass juice as a cure for cancer: it won’t help; it reduces the chance the patient will seek the right treatment; and it’s not cheap.

As if to prove the expense point, SPGI announced a new suite of ESG data tools 1 October that provide additional analytics but are only available to their Pro platform customers.

ESG rating schemes are not correlated, and there’s little transparency or consensus on the key issues (climate change, supply chain transparency, shareholder rights, and executive compensation), Armstrong says. Furthermore, high ESG ratings may drive outperformance once, but, thereafter, cost of capital differentials must mean underperformance as investors anticipate lower expected returns.

Back to Damodaran, who last month repeated “I am more convinced than ever that ESG is not just overhyped and oversold, but it’s become a gravy train for all the people who make money on ESG, and none of those people are in the groups that ESG is supposed to help.” You can read Damodaran’s post and watch his video on ESG here.

Since COVID-19, 43% of home appraisals have ‘down-valued’ purchases

Benham & Reeves, the London estate agency, reports that 43% of UK house sales since COVID-19 (through May 2021) were sold despite being down-valued by their RICS. This suggests a large number of buyers (about 350,000, according to the report) with signed purchase agreements experienced the sobering moment of sensing they’d paid more than they should.

Perhaps there’s a lesson here for business valuations. The role of official valuations of real property are not always understood by buyers—and perhaps less so in the artificial buying market for homes tax relief and the UK’s quantitative easing programmes partially create. Is the same true for BV? Is the reason for this that valuers don’t explain the process or their standards of value well?

Business valuation principles are often sidelined during M&A because the valuation, if it occurs at all, comes late in the process and after a lot of anecdotal evidence or “guesstimates” from both the buyer and the seller. The concept of market value has often been assumed into asking prices or negotiated (synergistic) offers long before any professional business valuation. Often, both sides of a business transaction have employed optimistic and probably unrealistic forecasts for both the tangible and intangible assets.

The acceleration of SPACs, which delist assets, and financial buyers who have financial strategies to accelerate earnings beyond open-market values contribute to what may be an increasing gap between business valuation and deal values. Much of this gap eventually ends up on balance sheets as goodwill, where it is often eventually impaired.

Are we as a profession failing to recognise the transaction market environment that often considers a business valuation to be unnecessary—or an administrative step in the closing process? When business valuations are performed earlier in the process and better understood by the principals, they become a benchmark for both buyers and sellers, so they must more consciously decide whether the deal is worth the additional consideration.

Best-practice examples in third FRC going-concern disclosure report emphasise business valuation

The Financial Reporting Lab of the Financial Reporting Council (FRC) has published its third thematic review of companies’ viability and going-concern disclosures, highlighting areas for improvement and offering examples of best practice. This current report recommends more thorough and bespoke disclosures of management’s plans around solvency and liquidity over the short, medium, and long term.

All of the new report’s recommendations require increased reliance on business valuation methods, including:

  • Increased modelling risks and uncertainties—FRC recommend disclosure of specific risk scenario modelling to support both going-concern and long-term viability conclusions.
  • Stronger inputs and assumptions—The report calls on financial experts to provide “more granular qualitative and quantitative detail of the inputs used and assumptions made.” All global business valuation standards obviously require disclosure of inputs and assumptions.
  • Clearer period-by-period risk assessments—Like revenues and expenses, FRC further recommend that company-specific risks be modelled over each forecasted financial period, another business valuation best practice. FRC mention risks inherent in the company’s business model, strategy and development, investment or capital allocation plans, and debt coverage.
The US takes on the valuation of Coca-Cola’s secret formula

Coke faces a more-than-$US 3 billion tax bill in a dispute over the valuation method used to determine the royalty charged to suppliers that provide the soda concentrate to bottlers—and the result of the case would impact transfer pricing taxes globally, given the brand’s reach. The US litigation will be an interesting case study with trademark valuation and transfer pricing implications in the UK and elsewhere.

US-based CPA Barry Sziklay (Friedman LLP) gave an update last week to the New Jersey Society of CPAs on Coca-Cola’s current “comparable profits method” for sharing gross sales between the parent company, international manufacturers of their syrup (supply points), and retailers. Sziklay said:

  • From 1996 to 2007, Coca-Cola had been using a “10-50-50” method that the IRS had approved in the wake of the agency’s audit of the company for the years 1987 to 1995. The 10-50-50 method permitted the supply points to retain as profits 10% of their gross sales, with the balance of the profit split 50-50 between the parent company and the supply points.
  • Then, the IRS audited the company for its 2007-to-2009 tax years and rejected the 10-50-50 method in favor of the “comparable profits method” for apportioning income between the U.S. parent company and its foreign supply points (which they, in turn, sell to unaffiliated bottlers worldwide). The comparable profit method (set forth in U.S. Treasury Reg. Sec. 1.482-5) attempts to determine an arm’s-length apportionment result based on the amount of operating profit an uncontrolled “comparable” company would earn in comparison to the subject company (The Coca-Cola Co. and subsidiaries).
  • Applying the new method, the IRS valuation expert calculated a more-than-$3 billion bill for back taxes. On 18 November 2020, the US Tax Court judge ruled in favor of the IRS. Sziklay told the conference audience that, on 21 June 2021, Coca-Cola filed a “motion for reconsideration.”

Sziklay believes “this case could end up before the U.S. Supreme Court,” with implications for the UK and the global minimum tax regime as the Organization for Economic Co-operation Development articulated in its July 2021 issuance of OECD/G20 Base Erosion and Profit Shifting Project, “Addressing the tax challenges arising from the digitalisation of the economy.”

BVWire—UK readers can find the US Tax Court opinion and continuing coverage on BVR’s BVLaw platform. The case is: Coca-Cola Co. v. Comm’r, 155 T.C No. 10 (Nov. 18, 2020). Also, BVR is providing a Gift and Estate Tax Valuation Update with Sziklay on 19 October.

Charles Stanley sale to US-based Raymond James approved

The wealth management market continues to consolidate, as shareholders of the longstanding City of London stockbroker Charles Stanley (CAY) approved a sale to Raymond James last week—at a 43% premium-to-share price. Both firms offer similar employed or self-employed affiliation models, but technology costs (Raymond James has one of the industry’s more robust wealth management platform offerings) and regulatory expenses are driving more consolidation for financial services in the UK and elsewhere.

Dates for your diary

6 October: Active and Passive Appreciation in Valuation: Finding the Line, 6:00 p.m.-7:40 p.m. BT. Featuring: Ashok B. Abbott (West Virginia University)

6-7 October: IVAS-IVSC Asia-Pacific Business Valuation Conference 2021, virtual

14 October: Valuation of UK Dental Practices, British Dental Association (BDA) online webinar, virtual 19:30 BT

24-26 October: ASA International Conference, Las Vegas and online

28 October: IVSC Annual General Meeting, 14:00 BT, virtual

8-11 November: IMAA’s Damodaran on Valuation, live online

1-9 December: Practical Business Valuation, ICAEW live online (four sessions) 09:30-12:30 BT

3-5 October 2022: 12th Annual International Valuation Conference, Riyadh, Saudi Arabia

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