Fairness opinions, the opinion of a financial advisor that the price of a prospective transaction is fair from a financial point of view, have been in the news recently for several reasons. The controversy involves conflicts of interest between providers of fairness opinions and other parties involved in the transactions. There has also been discussion as to whether even “unbiased” fairness opinions provide meaningful information. Since a fairness opinion is typically performed on behalf of either the buyer or seller, it reflects solely the fairness to that party and does not opine as to whether the deal is fair to the other party. A fairness opinion relates only to the price of the proposed transaction and not to any other deal terms, including the legal aspects.
The issues addressed by fairness opinions are important for companies in financial distress or for the asset managers of companies in bankruptcy. This is because there is greater uncertainty related to these companies and their assets. In such situations, it is understandable for parties to a potential transaction to rely on the independent advice provided by issuers of fairness opinions.
Fairness opinions are also of interest to anyone involved in the sale of companies, divisions of companies or corporate assets. Corporate board members and other fiduciaries use fairness opinions to demonstrate that they have used reasonable business judgment in approving a prospective transaction.
Recent Criticism of Fairness Opinions
Fairness opinions were of paramount importance in litigation related to the recently completed merger between the New York Stock Exchange (NYSE) and Archipelago Holdings, Inc. Various NYSE seatholders challenged the terms of the proposed merger, claiming that they should have received a larger portion of the merged company. (For the sake of full disclosure, my firm analyzed the investment banking documents and fairness opinions, and then advised the client and counsel to certain seatholders on the fairness of the deal.)
The judge in this case stated that fairness opinions “have become watered down and toothless.” He also stated that “conflicts between the board and financial experts who issue fairness opinions have become the norm instead of the exception.”
In one sense, the controversy surrounding fairness opinions is part of the larger picture of why shareholders have become skeptical of management. For example, there is evidence that acquisitions are often not in the best interests of the shareholders of the buyer. It is critical for shareholders to ascertain whether the deal is truly in their best interests, or if the deal merely serves the interests of management (who might have their own reasons to promote a deal) and their advisors (who often earn substantial fees upon deal completion). A “rubber stamp” fairness opinion might cause shareholders to approve a deal that they would not approve if they were more accurately informed of all relevant issues related to the pricing of the deal.
Conflict of Interest
A conflict of interest can arise when there are numerous parties involved on each side of a prospective deal. These parties might include one or more groups of owners, managers, independent directors, one or more investment banking firms and the company’s auditors.
Fairness opinions have often been performed on behalf of a company by that company’s investment bank and/or accounting firm. For reasons discussed below, these entities are generally unable to provide objective, unbiased information regarding a prospective transaction.
A fairness opinion ultimately opines on whether a prospective transaction is fair to the owners of the company. The issue of conflicts of interest in the issuance of fairness opinions ultimately addresses potential conflicts of interest between owners and other parties to the transaction. In some cases, depending on the capital structure of the company and the terms of the prospective deal, conflicts of interest can also arise between the various owners of the company.
Owners and Managers
At the outset, it is important to understand that the owners and managers of a company often have conflicting interests. For example, a manager who owns stock options might have an incentive to focus on the company’s short-term growth and profitability in order to boost the company’s stock price. This emphasis might come at the expense of the company’s long-term growth and profitability. Owners that are not employees might be more concerned with the company’s long-term growth, so the interests of management and other owners can diverge. This might lead a manager to pursue an acquisition at a price that is higher than the company should pay.
There are also non-quantitative areas in which the interests of owners and managers might diverge. One area simply involves the fact that managers have a built-in incentive to perform acquisitions simply because deals give visibility, attract attention, convey the perception of status and give the impression that management is “active,” or “doing something,” as opposed to “passive” and not so obviously taking big steps to improve the company. There is also the feeling that “bigger is better.”
Managers might also be influenced by advice and pressure from investment bankers. These investment bankers may have worked with the company in the past, or might simply be contacting company management to determine if there is an opportunity to put a deal together.
Owners and Investment Bankers
Fairness opinions have often been issued by an investment banker representing either the buyer or seller in a prospective deal. From one perspective, there is logic to this since the investment-banking firm might be familiar with many aspects of a company, including operations and financial projections, industry knowledge and management.
However, none of the abovementioned factors negate the fact that owners and investment bankers inherently have a major conflict of interest. This is because the investment banking firm typically receives a substantial fee only upon the completion of a deal. Therefore, the investment banking firm has a strong incentive to “close the deal,” regardless of whether the deal is in the interest of shareholders.
Owners and Accountants
Managers have sometimes relied on fairness opinions issued by a company’s accounting firm. The accounting firm has the incentive to agree with management because it is management that has a large voice in hiring the accounting firm. Even an accounting firm that is not currently being used by the company has the incentive to make management happy because they hope to get auditing or consulting work from the company in the future.
In any of these cases, the important factor is that the company issuing the fairness opinion has every incentive to agree with management.
These potential conflicts should be completely disclosed to all interested parties in the transaction. The National Association of Securities Dealers (NASD), the private-sector regulator of the U.S. securities industry, has taken this transparency issue further by proposing Rule 2290, which is currently being reviewed by the Securities and Exchange Commission. This new rule would provide investors with disclosure regarding the actual and potential conflicts of interest between the valuation agent rendering the fairness opinion and the company seeking the opinion. The rule would also require valuation agents to examine their fairness opinion process in order to identify such conflicts of interest.
Validity of “Independent” Fairness Opinions
Even when there are no obvious conflicts of interest, there are still some reasons why an “independent” fairness opinion might not truly serve the interests of owners.
When an investment-banking firm is retained to perform a fairness opinion for a company with which it has no other business relationship, there is still an incentive for the investment-banking company to issue a positive fairness opinion. This is because investment-banking firms have an incentive to promote a high level of merger and acquisition activity since they ultimately expect other fees from merger activity.
There are other incentives for investment-banking firms to help one another under the presumption where one investment-banking firm expects to receive reciprocate business or additional business from another investment-banking firm. There are many ways investment-banking firms can “help” each other, including asking the investment-banking firm involved in the deal to perform a fairness opinion for a deal in which it is performing an investment-banker role, and allowing other investment-banking firms to participate in initial public offerings (IPOs) and other capital transactions.
Another reason that even “independent” fairness opinions may not provide meaningful information reflects the fact that any fairness opinion can only be as good as the underlying data. A fairness opinion that is prepared with the best of intentions, but relies on flawed data, can result in owners and fiduciaries having to make a decision without having received accurate guidance from the firm issuing the fairness opinion.
There are many ways in which financial information can provide misleading valuation and deal price information. A company’s historical financial statements may not reflect the value inherent in the company’s operations going forward for several reasons. First, the historical financial statements might include revenue and/or expense items that are not expected to recur, and for which the financial statements used by the fairness opinion provider have not been properly adjusted. Second, the company and/or the industry might be undergoing substantial change.
Similarly, financial projections can provide misleading information as to the value of a company. The projections might incorporate unrealistically optimistic and pessimistic growth and profitability assumptions. In addition, financial projections might be “missing a piece of the puzzle” by not contemplating other areas of business that the company might enter as a stand-alone company or in combination with prospective buyers or sellers.
It is important to understand that providers of fairness opinions and business appraisers typically do not participate in the preparation of financial projections. It is the job of the financial professional to understand the financial statements and properly assess the level of risk inherent in the financial statements. A good business appraiser or fairness-opinion provider will demonstrate the ability to perform a sufficient amount of due diligence and analysis necessary to properly estimate the value of a company and/or the price of a prospective deal.
Relative Fairness vs. Absolute Fairness
An additional concern in some transactions is that there are different ownership groups of a company that is being sold. It is possible for a deal to be fair in the aggregate (i.e., the total price is fair to all owners) but still be unfair to certain owners. One example of this is when certain owners have restrictions on securities that they will receive in a transaction that are different from otherwise similar securities that will be received by other owners. If the terms of the deal do not properly account for these differences, it is possible that the deal might not be fair to some owners of the selling company but not to other owners. It is important to note that disclosing these differences is not the same thing as accounting for these differences.
What a Fairness Opinion Is Not
A fairness opinion is not a valuation analysis. More importantly, a positive fairness opinion is not a conclusion that the price of the subject deal is the only possible price at which the transaction could be considered to be fair from a financial point of view.
In analyzing deal prices and fairness opinions, it is important to understand different definitions of value. In the business valuation profession, the following two measures of value are relevant to this discussion: (1) fair market value, defined as the price “between a willing seller and a willing buyer when neither is acting under compulsion and when both have reasonable knowledge of the relevant facts,”1 and (2) investment value, which is value to a specific investor or owner. Investment value typically includes the value of synergies between the buyer and the seller. From one perspective, these definitions of value form the upper and lower boundaries of the price of a potential deal. A deal should normally not take place at a price that is below fair market value; there should always be a buyer prepared to pay at least that amount. The highest price a bidder would normally offer is the investment value of the target company to that bidder.
The price at which a deal ultimately occurs may reflect a number of factors, such as the competitive environment for companies in a particular industry and the needs of individual buyers. For a company that is for sale, but for which there is a small number of potential buyers, for example, the price may be at or slightly above the fair market value of the seller. Alternatively, if there are a large number of bidders, the ultimate price would be expected to reflect the investment value of the top bidders. A final consideration might simply be the relative negotiating ability of the parties.
Of course, it is not possible for a company in bankruptcy or its assets to be sold without compulsion. The financial and operating condition of the parties to a transaction are important considerations in assessing the fairness of a deal.
This controversy over fairness opinions may mean a change in the landscape of fairness-opinion providers. There is clearly an increased role for valuation firms since fairness opinions are based on common-valuation methodologies. This is particularly so for providers of fairness opinions that are not also involved in investment banking, audit or other consulting work that might affect objectivity. If the investment bankers and accounting firms start limiting the number of fairness opinions that they issue due to potential or real conflicts of interest, then this will affect the makeup of firms providing fairness opinions. There is evidence that fiduciaries are increasingly seeking truly unbiased advice on proposed deals. Many independent directors are contacting valuation and/or fairness-opinion providers for advice even before receiving a formal offer.
The NYSE transaction initially had two firms issuing fairness opinions, and a third fairness opinion was issued in settlement of litigation regarding the deal. It would be a safe assumption that future deals will increasingly rely on truly independent fairness opinions.
Conclusion
In today’s financial world, it is more important than ever for parties involved in the sale of companies and assets to obtain knowledgeable and unbiased financial advice concerning valuation-related aspects of these transactions. This is particularly true in cases involving the sale of business interests or assets of companies that are in financial distress or bankruptcy because of the difficulty of estimating the value of these assets and companies. Therefore, it is important for the bankruptcy executive to be knowledgeable of these issues related to fairness opinions in order to ensure that the transaction proceeds smoothly for all parties involved.