DIGEST - CBV InstituteRisk Premium Created by Taxation . . . . . .18 The Business Valuation Digest...

IN THISISSUE

BUSINESS VALUATIOND I G E S T

VOLUME 10

ISSUE 2

DECEMBER 2004

BY GEOFFREY CULLINAN, JEAN-MARC LE ROUX, AND ROLF-MAGNUS WEDDIGEN

The Canadian Institute of Chartered Business Valuators

A publication devotedto articles on BusinessValuation and relatedmatters.

When to Walk Away From a Deal

When to Walk Awayfrom a Deal . . . . .1

Shareholder Rights and Valuation Issues:DramaticDevelopments in FordMotor Co. of Canada,Ltd. v. OMERS . . . . . . . . . . . .10

CAPM and Business Valuation . . . . . .14

The Higher Equity Risk PremiumCreated by Taxation . . . . . .18

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Institute or the Editorial Advisory

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EDITOR:

Carl A. Merton, CA, CBV

EDITORIAL ADVISORY BOARD:

Mark L. Berenblut, CA, CBV

Howard Johnson, CA, CBV, CPA

Blair Roblin, CBV, LLB

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Deal making is glamorous; due diligence isnot. That simple statement goes a long waytoward explaining why so many companieshave made so many acquisitions that haveproduced so little value. Although bigcompanies often make a show of carefullyanalyzing the size and scope of a deal inquestion – assembling large teams andspending pots of money – the fact is, themomentum of the transaction is hard toresist once senior management has the targetin its sights. Due diligence all too oftenbecomes an exercise in verifying the target’sfinancial statements rather than conducting afair analysis of the deal’s strategic logic andthe acquirer’s ability to realize value from it.Seldom does the process lead managers tokill potential acquisitions, even when thedeals are deeply flawed.

Take the case of Safeway, a leadingAmerican grocery chain with a string ofsuccessful mergers to its credit and a highlyrespected management team. In 1998,Safeway acquired Dominick’s, an innovativeregional grocer in the Chicago area. Thestrategic logic for the $1.8 billion dealseemed impeccable. It would add about 11%to Safeway’s overall sales at a time when massretailers like Wal-Mart and Kmart werestocking groceries on their shelves and takingmarket share away from established players,and it would give Safeway a strong presencein a major metropolitan market.

Although Dominick’s 7.5% operating cashflow margin lagged behind Safeway’s 8.4%,Safeway CEO Steve Burd convinced investors

that he would be able to quickly raise theacquired firm’s margin to 9.5%. Capitalizingon this momentum, Safeway closed the dealin just five weeks, about a third of theaverage closing period for large acquisitions.

Safeway would come to regret not takingtime for due diligence. Dominick’s focus onprepared foods, in-store cafes, and productvariety did not fit Safeway’s emphasis onstore brands and cost discipline. Dominick’sstrong unions resisted Safeway’s aggressivecost-cutting plans. And with its customersunwilling to accept Safeway’s private labelgoods, Dominick’s was soon losing share toits archrival, Jewel. A thorough due diligenceprocess would certainly have revealed theseproblems, and Safeway could have walkedaway with its pockets intact. Instead, it isstuck with an operation it cannot sell foreven a fifth of the original purchase price.

Safeway is just one of many companies tosuffer from weak due diligence. In December2002, Bain & Company surveyed 250international executives with M&Aresponsibilities. Half the participants saidtheir due diligence processes had failed touncover major problems, and half found thattheir targets had been dressed up to lookbetter for the deals. Two-thirds said theyroutinely overestimated the synergiesavailable from their acquisitions. Overall, only30% of the executives were satisfied with therigor of their due diligence processes. Fully athird admitted they hadn’t walked away fromdeals they had nagging doubts about.

What can companies do to improve their

B U S I N E S S V A L U A T I O N D I G E S T2

due diligence? To answer that question, we’vetaken a close look at 20 companies – bothpublic and private – whose transactions havedemonstrated high-quality due diligence.

We calibrated our findings against ourexperiences in 2,000-odd deals we’vescreened over the past ten years. We’ve foundthat successful acquirers view due diligence asmuch more than an exercise in verifyingdata. While they go through the numbersdeeply and thoroughly, they also put thebroader, strategic rationale for theiracquisitions under the microscope. They lookat the business case in its entirety, probingfor strengths and weaknesses and searchingfor unreliable assumptions and other flaws inthe logic. They take a highly disciplined andobjective approach to the process, and theirsenior executives pay close heed to the resultsof the investigations and analyses – to theextent that they are prepared to walk awayfrom a deal, even in the very late stages ofnegotiations. For these companies, duediligence acts as a counterweight to theexcitement that builds when managers beginto pursue a target.

The successful acquirers we studied were allconsistent in their approach to due diligence.Although there were idiosyncrasies anddifferences in emphasis placed on theirinquiries, all of them built their due diligenceprocess as an investigation into four basicquestions:

! What are we really buying?

! What is the target’s stand-alone value?

! Where are the synergies – and the skeletons?

! What’s our walk-away price?

In the following pages, we’ll examine eachof these questions in depth, demonstratinghow they can provide any company with asolid framework for effective due diligence.

What Are We Really Buying?When senior executives begin to look at anacquisition, they quickly develop a mentalimage of the target company, often drawingon its public profile or its reputation within

T H E C A N A D I A N I N S T I T U T E O F C H A R T E R E D B U S I N E S S V A L U A T O R S

the business community. That mental image shapesthe entire deal-making process – it turns into thestory that management tells itself about the deal.An effective due diligence process challenges thismental model, getting at the real story beneath theoften heavily varnished surface. Rather than relyon secondary sources and biased forecasts providedby the target company itself, the corporate suitormust build its own proprietary, bottom-up view ofthe target and its industry, gathering informationabout customers, suppliers, and competitors in thefield.

Bridgepoint, a leading European private equityfirm, is particularly adept at this kind of strategicdue diligence. In 2000, Bridgepoint was consideringbuying a fruit-processing business from the Frenchliquor giant Pernod Ricard. The business, which forthe purposes of this article we’ll call FruitCo,looked like an attractive acquisition candidate. Asthe leading producer of the fruit mixtures used toflavor yogurt, it was well positioned in a growingindustry. Western consumers had been spendingbetween 5% and 10% more each year on yogurt,and the market was growing faster still in thedeveloping world, particularly in Latin America andAsia. FruitCo was posting profits and had wonpraise for its innovativeness and its excellence inR&D and manufacturing. Moreover, there wasnothing suspicious about Pernod Ricard's reasonsfor selling – fruit processing simply lay outside itscore business.

FruitCo looked like a winner to Benoit Bassi, amanaging director of Bridgepoint in Paris. He sawattractive opportunities to boost FruitCo's revenuesand profits by expanding the business into adjacentcategories, such as ice cream and baked goods, aswell as into new channels. After laying out the casefor the acquisition in a grueling five-hour meetingwith his partners, Bassi got the OK to pursue thedeal. Yet it never happened; just four weeks later,Bassi killed it.

During those four weeks, the due diligence teamhad discovered many worms in the shiny FruitCoapple. They tested the argument that FruitCo couldmake money by scaling up and competing on cost,for instance. And they found that while thecompany boasted considerable global scale, regionalscale turned out to be the more relevant driver ofcosts. That was because the economics of

B U S I N E S S V A L U A T I O N D I G E S T 3

What is the target's track record in retainingcustomers? Where could you adjust itsofferings to grow sales or increase prices?What channels does the target use to serve itscustomers, and how do those channels matchyour own? In researching these questions,effective due diligence teams remember alwaysto identify the target's most profitablecustomers and look at how well the target ismanaging them. They don't rely on what thetarget tells them about its customers; theyapproach the customers directly.

Check out the competition. Good duediligence practitioners always examine thetarget's industry presence.

How does it compare to its rivals in terms ofmarket share, revenues, and profits bygeography, product, and segment? They lookat the pool of available profits and try todetermine whether the target is getting a fair(or better) share of industry profits comparedwith its rivals. How does each competitor makethe profits expected from a company with itsrelative market share? Where in the valuechain are profits concentrated? Is there a wayto capture more? Is the targetunderperforming operationally? Are itscompetitors? Is the business correctly defined?The due diligence team should carefullyconsider how competitors will react to theacquisition and how that might affect thebusiness. Once again, effective teams don't relyon what the target tells them; they seekindependent advice.

Verify the cost economics. Successful duediligence teams always ask the followingquestions about costs: Do the target'scompetitors have cost advantages? Why is thetarget performing above or below expectationsgiven its relative market position? What is thebest cost position the acquirer could reasonablyachieve? The team also needs to look at theextent to which the target is using itsexperience in the market to drive down costs.When considering postmerger opportunitiesfor cost rationalization, the team needs toassess whether the benefit of sharing costs withother business units will outweigh the lack offocus that sharing costs across multiple


transportation and purchasing made the globalsourcing of fruit – a major cost component –unfeasible. At the same time, advanced processingtechnologies enabled FruitCo's rivals to achievecompetitive economics at the country level. Whenthe team tested FruitCo's price and revenueforecasts, they found further cause for concern.The market for fruit yogurt was indeed growing,but profitability in many markets – particularly inLatin America – was falling rapidly, indicating thatthe product was turning into a commodity.Stemming this trend seemed unlikely; consumerstold Bridgepoint’s researchers that they would beunlikely to tolerate increased prices. The team thenpored over the target company’s customer lists.They found that FruitCo was highly dependent onsales to two large yogurt producers, both of whichseemed intent on achieving more control over theentire production process in each major marketthat they competed in. FruitCo seemed fated to anerosion of market power – it would have to fightfor every contract.

Bassi recognized that the original business casefor the acquisition did not hold up under closescrutiny. He walked away from the deal he hadonce coveted, probably saving Bridgepoint millionsof dollars in the process. “What we thought weknew turned out to be wrong,” Bassiunsentimentally explains.

As the story suggests, effective acquirerssystematically test a deal's strategic logic. LikeBridgepoint, they typically organize theirinvestigations around the four Cs of competition:customers, competitors, costs, and capabilities (oftenbut not necessarily in that order). Within each ofthese areas, due diligence teams ask hard questionsas they study their targets. Although they will relyon information provided by the targets, they do notaccept those data at face value. They conduct theirown field analyses.

Get to know the customers. Good due diligencepractitioners begin by drawing a map of theirtarget's market, sketching out its size, its growthrate, and how it breaks down by geography,product, and customer segment. This allows themto compare the target's customer segments – theirprofitability, promise, and vulnerability – with thoseof its competitors. Has the target fully penetratedsome customer segments but neglected others?



businesses might introduce. It needs todetermine how low it can take costs byinstituting best practices. Benchmarking can bean important aid here. It's also vital to look athow to allocate costs going forward. Whichproducts and customers really make the money,and which ones should be dropped?

Take stock of capabilities. Effective acquirersalways remember that they are not just buyinga P&L and a balance sheet but also capabilitiessuch as management expertise. Capabilities maynot be easy to measure, but taking them forgranted is too large a risk for any companybecause competencies largely determine howwell a company will be able to pursue itspostacquisition strategy. Acquirers should askthemselves: What special skills or technologiesdoes the target have that create definablecustomer value? How can it leverage those corecompetencies? What investments in technologyand people will help buttress the existingcompetencies? What competencies can thecompany do without? Assessing capabilities alsoinvolves looking at which organizationalstructures will enable the business to implementits strategy most effectively. How should allother aspects of the organization (such ascompensation, incentives, promotion,information flow, authority, and autonomy) bealigned with the strategy?

In testing a deal's strategic logic, mostcompanies will be on the lookout for potentialproblems – the smoking guns, the skeletons inthe closets. But the due diligence process canproduce nice surprises as easily as nasty ones,and it may give a would-be acquirer a reasonto pursue a deal more aggressively than itotherwise might have. Centre Partners’acquisition in the late 1990s of AmericanSeafoods, a fishing company, is a case inpoint.(See Uncovering Hidden Treasure onpage 9).

What Is the Target's Stand-Alone Value? Once the wheels of an acquisition are turning,it becomes difficult for senior managers to stepon the brakes; they become too invested in thedeal's success. Here, again, due diligence

should play a critical role by imposing objectivediscipline on the financial side of the process. Whatyou find in your bottom-up assessment of thetarget and its industry must translate into concretebenefits in revenue, cost and earnings, and,ultimately, cash flow. At the same time, the target'sbooks should be rigorously analyzed not just toverify reported numbers and assumptions but alsoto determine the business's true value as a stand-alone concern. The vast majority of the price youpay reflects the business as is, not as it might beonce you've won it. Too often the reverse is true:The fundamentals of the business for sale areunattractive relative to its price, so the searchbegins for synergies to justify the deal.

Of course, determining a company's true value iseasier said than done. Ever since the old days ofthe barter economy, when farmers wouldexaggerate the health and understate the age of thelivestock they were trading, sellers have always triedto dress up their assets to make them look moreappealing than they really are. That's certainly truein business today, when companies can use a widerange of accounting tricks to buff their numbers.

Here are just a few of the most commonexamples of financial trickery used:

! Stuffing distribution channels to inflate salesprojections. For instance, a company may treat asmarket sales many of the products it sells todistributors – which may not represent recurringsales.

! Using overoptimistic projections to inflate theexpected returns from investments in newtechnologies and other capital expenditures. Acompany might, for example, assume that a majoruptick in its cross selling will enable it to recoup itslarge investment in customer relationshipmanagement software.

! Disguising the head count of cost centers bydecentralizing functions so you never see the fullpicture. For instance, some companies scatter themarketing function among field offices andmaintain just a coordinating crew at headquarters,which hides the true overhead.

! Treating recurring items as extraordinary costs toget them off the P&L. A company might, forexample, use the restructuring of a sales networkas a way to declare bad receivables as a onetimeexpense.

! Exaggerating a Web site's potential for being an effective, cheap sales channel.

! Underfunding capital expenditures or sales, general, and administrative costs in the periods leading up to a sale to make cash flow look healthier. For example, a manufacturer may decide to postpone its machine renewals a year or two so those figures won't be immediately visible in the books. But the manufacturer will overstate free cash flow – and possibly mislead the investor about how much regular capital a plant needs.

! Encouraging the sales force to boost sales while hiding costs. A company looking for a buyer might, for example, offer advantageous terms and conditions on postsale service to boost current sales. The product revenues will show up immediately in the P&L, but the lower profit margin on service revenues will not be apparent until much later.

To arrive at a business's true stand-alone value,all these accounting tricks must be stripped away toreveal the historical and prospective cash flows.Often, the only way to do this is to look beyondthe reported numbers – to send a due diligenceteam into the field to see what's really happeningwith costs and sales.

That's what Cinven, a leading European privateequity company, did before acquiring OdeonCinemas, a UK theater chain, in 2000. Instead oflooking at the aggregate revenues and costs, asOdeon reported them, Cinven's analysts combedthrough the numbers of every individual cinema inorder to understand the P&L dynamics at eachlocation. They were able to paint a rich picture oflocal demand patterns and competitor activities,including data on attendance, revenues, operatingcosts, and capital expenditures that would berequired over the next five years. Thismicroexamination of the company revealed that theinitial market valuation was flawed; estimates ofsales growth at the national level were not justifiedby local trends. Armed with the findings, Cinvennegotiated to pay 45 million less than the originalasking price.

Getting ground-level numbers usually requires theclose cooperation of the acquisition target's topbrass. An adversarial posture almost alwaysbackfires. Cinven, for example, took pains to



explain to Odeon's executives that a deepunderstanding of Odeon's business wouldhelp ensure the ultimate success of themerger. Cinven and Odeon executivesworked as a team to examine the results ofeach cinema and to test the assumptions ofOdeon's business model. They held fourdaylong meetings in which they went througheach of the sites and agreed on the mostimportant levers for revenue and profitgrowth in the local markets. Although theprocess may strike the target company asexcessively intrusive, target managers will findthere are a number of benefits to going alongwith it beyond pleasing a potential acquirer.Even if the deal with Cinven had fallen apart,Odeon would have emerged from the deal'sdue diligence process with a much betterunderstanding of its own economics.

Of course, no matter how friendly theapproach, many targets will be prickly. Thecompany may have something to hide. Or thetarget's managers may just want to retaintheir independence; people who believe thatknowledge is power naturally like to hold onto that knowledge. But innocent or not, atarget's hesitancy or outright hostility duringdue diligence is a sign that a deal's value willbe more difficult to realize than originallyexpected. As Joe Trustey, managing partnerof private equity firm Summit Partners, says:“We walk away from a target whosemanagement is uncooperative in duediligence. For us, that's a deal breaker.”

Where Are the Synergies –and the Skeletons?It's hard to be realistic about the synergies anacquisition will deliver. In the feveredenvironment of a takeover, managersroutinely overestimate the value of cost andrevenue synergies and underestimate thedifficulty of achieving them. It's worthrepeating that two-thirds of the executives inour M&A survey admitted to havingoverestimated the synergies available fromcombining companies.

Realizing that synergy estimates are oftenuntrustworthy, some companies have made it

It's important that this analysis also explicitlyconsider the cost of achieving the synergies, inboth cash and time. In one dramatic case, theCanadian real estate companies O&Y Propertiesand Bentall Capital called off their plannedmerger in 2003 after tallying up the integrationcosts necessary to realize the synergies. O&Ymanaged properties throughout eastern Canada,while Bentall's holdings were concentrated in theWest. In addition to complementing each othergeographically, the two companies believed theycould rationalize expenses over a largercollection of properties and still haverepresentatives on the ground in every majorNorth American city. Yet, after due diligence,both sides realized that the high costs ofintegration would likely overwhelm any long-runsavings and revenue gains. Bentall presidentGary Whitelaw told the press that his companyhad grown “increasingly concerned that the scaleof the integration could divert resources awayfrom our primary objective. The merger riskswould have been significant, demandingincreased management attention, and resultingin larger integration costs than at first may havebeen thought.” The deal was scuttled, to thebenefit of O&Y's and Bentall's shareholders.

It is perhaps understandable that managersmight want to put off thinking about thesensitive issues inherent in integration planninguntil after the deal is signed and sealed. Butthat is often a serious mistake. Integrationplanning – and the costs of integration – areamong the biggest determinants of anacquisition's ultimate success or failure, and youcan't really declare a due diligence processcomplete unless you've looked closely at thosecosts. The due diligence team's deep knowledgeof the acquisition target makes it an ideal bodyto develop an initial road map for combiningtwo companies' staffs and operations.

In addition to examining the cost of achievingpositive synergies, the due diligence team alsoneeds to consider how potential conflictsbetween the merged businesses may saprevenues or add costs. These negative synergies– the skeletons in the closet of every deal – cantake many forms. Once two companies combinetheir accounts, for example, some of their joint



their policy not to take potential synergies intoaccount when determining the value ofacquisition candidates. Although the concernbehind the policy is understandable, such anapproach can be destructive: Some synergiesare achievable, and ignoring them may steercompanies away from smart acquisitions. Abetter approach is to use the due diligenceprocess to carefully distinguish betweendifferent kinds of synergies, and then estimateboth their potential value and the probabilitythat they can be realized. That assessmentshould also include the speed with which thesynergies can be achieved and the investments itwill take to get them.

We've found it useful to think of potentialsynergies as a series of concentric circles, asshown in the exhibit, “A Map of Synergies.”(As a result of copyright issues, we are unable toreproduce the exhibit referred to above. - Editor).The synergies at the center come fromeliminating duplicate functions, businessactivities, and costs – for instance, combininglegal staffs, treasury oversight, and boardexpenses. These are the easiest synergies toachieve; companies are sure to realize most ofthe potential savings here. The next closestcircle represents the savings realized fromcutting shared operating costs, such asdistribution, sales, and regional overheadexpenses. Most companies will realize themajority of these savings, as well. Then comethe savings from facilities rationalization, whichare typically more difficult to achieve becausethey can involve significant personnel andregulatory issues. Farther out are the moreelusive revenue synergies, starting with sales ofexisting products through new channels andmoving to the outermost circle, selling newproducts through new channels. Each circleoffers large rewards, but the farther out thesavings or revenues lie, the more difficult theybecome to achieve and the longer it will take.Categorizing synergies in this way provides auseful framework for valuing them. Analystscan assign to each circle a potential value, aprobability for achieving the value, and atimetable for implementation, which can beused to model the synergies' effect on thecombined cash flows of the companies.

For a walk-away price to have meaning,you really have to be willing to walk away. Auseful lesson in that regard comes fromKellogg's CEO, Carlos Gutierrez, whonegotiated the purchase of Keebler.Gutierrez dearly wanted to close the deal.Keebler's vaunted direct-to-store deliverysystem enabled it to carry products to storesin its own trucks, bypassing the retailers'warehouses altogether. Gutierrez sawenormous potential for funneling Kelloggproducts through Keebler's highly efficientsystem. But Kellogg's rigorous due diligenceanalysis made it clear that the maximum heshould pay for Keebler was $42 a share,which he expected was less than whatKeebler was looking for. “Even though thiswas a deal that we desperately wanted,”Gutierrez later recalled, “I conditionedmyself mentally to say we might not have it.”In a final bargaining session in New York,Gutierrez told Keebler's management that ashare price of $42 was his maximum offer –and that if they could get more fromsomeone else, they should take it. Gutierrezwent off to watch a Mets game, determinednot to give any more thought to thenegotiation. Two days later, Keebler acceptedGutierrez's offer.

To establish a walk-away price, successfuldeal makers convene a decision-making bodyof trusted individuals who are less attachedto the deal than senior management is. Theyinsist on senior management's approval ofthe body and establish a decision-makingprocess that clearly delineates who in thecompany recommends deals, who holds vetopower, whose input should be solicited, andwho decides yea or nay in the final instance.They adopt formal checks and balances thatrely on predetermined walk-away criteria.

Bridgepoint assembles a team of sixmanagers, each of whom represents one offour viewpoints. One is the prosecutor, whoplays the role of devil's advocate. The secondis the less-experienced manager, whoseinvolvement is a key part of his or hertraining. The third is a senior managingdirector, who no longer has any hierarchical

customers may curtail their purchases for fear ofbeing overly reliant on a single supplier. Difficultiesin integrating back-office operations or systems mayat least briefly impede customer service and orderfulfillment, leading to a loss of sales. Seeing morecompetition for promotions, talented employeesmay leave, sometimes taking customers with them.And the inevitable distractions of a merger mayforce management to pay less attention to the corebusiness, undermining its results. Despite theiroften immense importance, negative synergies areroutinely overlooked in due diligence. A commonmistake, for example, is to create a valuation modelthat adds up the revenues of the two companies,plus the synergies, without subtracting an estimatedamount for revenue erosion or increased costs.

Even the best acquirers will encounter negativesynergies. An executive who left cereal giantKellogg after its 2001 merger with biscuit makerKeebler told us that the company experiencednegative synergies when it decided to put new-product launches on hold in order to focus onintegrating the two companies. Some potentialrevenues were lost as a result even though Kelloggmet its targets for cost reductions. A moredevastating example of negative synergies occurredin the 1996 merger of the Southern Pacific and theUnion Pacific railroads. Incompatibilities in thecompanies' information systems, combined withother operating conflicts, created massivedisruptions in rail traffic throughout the westernUnited States, leading to delayed and misroutedshipments and irate customers. In the end, thegovernment had to declare a federal transportationemergency.

What's Our Walk-Away Price?The final leg of a sound due diligence process isdetermining a walk-away price – the top price youare willing to pay when the final price negotiationis conducted.

The walk-away price should never include the fullpotential value of the synergies, which is why it'simportant to calculate the deal's stand-alone valueseparately. Synergies – especially the elusive outer-circle synergies – are something that you target inmanaging a completed acquisition; they should notunduly influence the negotiation of the deal unlessyou can be fairly certain about the numbers.



equity firms are particularly good models in thisregard, since they look at every potential dealcoldly, without bias or over-confidence. AsBridgepoint's Benoit Bassi puts it, “When you workfor a corporation and you buy something you thinkis in your core business or fits with your corebusiness, you assume you know what you arebuying. By contrast, .125 private equity investors.375 have to rediscover everything. There can be acertain arrogance in corporations, which causesthem to make silly mistakes.” And those sillymistakes can end up costing companies millions, oreven billions, of dollars.

Uncovering Hidden Treasure A comprehensive due diligence effort can uncovergood news as well as bad. In some cases, it caneven lead a company to make a strong acquisitionthat it might otherwise have passed up. That's whathappened when the private equity firm CentrePartners looked into buying a fishing companycalled American Seafoods in the late 1990s. Thecompany caught and processed Alaskan pollock andother species from seven fishing trawlers operatingin U.S. waters in the Bering Sea. At the time,American Seafoods was owned by a Norwegianparent company. But when the U.S. Congressenacted a law that made it illegal for a foreignconcern to own companies fishing in Americanwaters, the Norwegian parent was forced to sell.

Although American Seafoods' profits jumped in1999 – its EBITDA hit $60 million that year, morethan double the annual average of approximately$26 million in the three preceding years – thefishing business did not, at first blush, seemparticularly attractive to Centre Partners.Historically subject to wide swings in supplies andprices and under increasingly tight regulation, thebusiness seemed fated to volatile and potentiallyweak returns. But when Centre Partners sent in acrack due diligence team, combining experts inconsumer products, fishing operations, and marinebiology, it found that, far from being a blip,American Seafoods' profit boom appearedsustainable.

The team's global analysis of the health of majorfisheries turned up the most interesting data.Centre Partners discovered that the total biomass ofthe U.S. Alaskan pollock fishery was expected togrow in coming years, while the biomasses of



function at the company and who thereforecannot be undermined by corporate politics.The final members of the panel aremanaging directors who still have operationalroles. The team's goal is to provide athorough, balanced, and unbiasedexamination of the acquisition candidate andhold everyone's feet to the fire on walk-awaycriteria. “That makes quite a balancedwhole,” says Bridgepoint's Bassi. “Is itperfect? I don't know. But it works.”

Companies can also adjust theircompensation systems as added incentiveagainst overpaying for deals. For instance, atClear Channel, an international radio,billboard, and live entertainment company,line managers have to sign off “in blood,” asCFO Randall Mays puts it, on the cash flowsthat any acquisitions will deliver. Thecompany ties managers' future compensationto meeting the division's cash flowprojections, which include results from thoseacquisitions. The salaries for Clear Channel'sM&A teams are also tied to the contributionthat acquisitions make to the company'sfinancial performance. The divisionpresidents and M&A teams meet Mays atyear's end to study all the acquisitions theyhave made in the previous three years to seewhether they delivered what they promisedand to review compensation at the sametime. As Mays puts it, the deals they make“are tied to them forever.”

The backward-looking science of duediligence is vital. But it is a meaninglessexercise without the forward-looking art ofstrategic due diligence. In the wake of somany disappointing mergers and acquisitions,more and more organizations are realizingthat there are few better ways of spendingmanagers' time and investors' money than ina careful and creative analysis of anacquisition candidate.

In the end, effective due diligence is asmuch about managerial humility as anythingelse. It's about testing every assumption andquestioning every belief. It's about not fallinginto the trap of thinking you'll be able to fixany problem after the fact. The best private

competing fisheries – Russian Alaskan pollock andAtlantic cod, most notably – were dropping, someat a fast clip. Overall supplies of pollock and codwould fall, in other words, but the share of themarket represented by U.S. Alaskan pollock wouldprobably rise. That was good news from a revenueand pricing standpoint, and the news got evenbetter when the due diligence team looked moreclosely at trends in fish prices.

Although pollock prices had recently increased, asoverall supplies fell, they remained well below thelevels of competing whitefish like cod,

tilapia, and hoki. As a result, there seemed littlechance that pollock would be subject to significantprice competition for the foreseeable future. Thebig Japanese market for pollock roe, meanwhile,remained strong while supplies were falling, leadingto a sharp and sustainable increase in roe pricesthat seemed likely to benefit American Seafoodswell into the future.

Based on the results of the due diligence analysis,Centre Partners made a successful bid for AmericanSeafoods. It turned out to be quite a catch. Withinthree years, EBITDA grew to $109 million, and theprivate equity firm had recapitalized the companyand sold a portion of its stake. Today, the firm isexploring an initial public offering. In the process,Centre Partners realized nearly four times its initialinvestment and retained control of the business asit sought to further grow revenue and increaseprofits.



Geoffrey Cullinan ([email protected])

directs Bain & Company's European private equity

practice from London. Jean-Marc Le Roux (Jean-

[email protected]), in Paris, and

Rolf-Magnus Weddigen (Rolf-

[email protected]), in Munich, also

work in Bain's European private equity practice

c. 2004 Harvard Business Review. This article

originally appeared in the April 2004 edition of

the Harvard Business Review and is reprinted

with permission.

Introduction A recent decision of the Ontario SuperiorCourt of Justice in Ford Motor Company ofCanada v. OMERS2 re-opened a number ofvaluation and corporate law issues that mostobservers believed to be well resolved. Therelevance of these legal/valuation issues toAmerican businesses with Canadianoperations makes these issues worthy ofexamination.

The Litigants Ford Motor Company of Canada ("FordCanada"), as the name suggests, is theCanadian subsidiary of Ford Motor Company("Ford U.S."). Ford U.S. owned 94 percent ofFord Canada's issued and outstanding shares.The remaining 6 percent were publiclytraded and were, in part, owned by OMERS,the Ontario Municipal Employees RetirementBoard, one of Canada's largest pension funds.

In 1995, Ford decided to "go private," amechanism whereby a shareholder who ownsa certain percentage of the shares of acorporation can buy out the remainingshareholders.

If the minority shareholder does not likethe price being offered on such an event,either the corporation or the minorityshareholders can apply to the Court to havethe fair value of the shares determined. Thisjudicial valuation will then determine theprice at which the shares are purchased.



Valuation/Corporate Law IssuesFord raises two important valuation and corporatelaw issues:

1. corporate liability to minority shareholders for improprieties in transfer pricing arrangements, and

2. whether rights attach to shares or to shareholders.

The critical issue in the case was Ford's historicaltransfer pricing policies. The minority shareholderinvoked the shareholder oppression remedy foundin Canada's federal corporate statute (as well as inmost provincial corporate statues). The shareholderoppression remedy gives individual shareholders,3

the right to bring a personal claim for corporatewrongdoing.

In Ford, minority shareholders argued successfully(1) that the transfer pricing policies between FordU.S. and Ford Canada were oppressive to minorityshareholders and (2) that compensation to correctthat oppression should be factored into the fairvalue calculation of their shares.

Although the minority shareholders weresuccessful on this point, the Court distinguished thiscase from prior case law. The Court held that acomplainant under the shareholder oppressionremedy had to have standing as a complainant atthe time the oppression occurred.

In other words, a shareholder could onlycomplain about the transfer pricing issues thatoccurred while he or she was a shareholder. Ashareholder could not complain about transferpricing issues that arose before he or she became ashareholder.

This conclusion raises a fundamental corporateand valuation issue of whether rights attach (1) toshares or (2) to shareholders. Until Ford, the issuehad been relatively settled in Canada in favor of therights attaching to shares.

BY MARKUS KOEHNEN Shareholder Rights and ValuationIssues: Dramatic Developments inFord Motor Co. of Canada, Ltd. v.OMERS

Facts of the CaseDuring the course of going private, Ford Canadaoffered $185 per share to its minority shareholders.Fifty-three percent of the minority shareholdersdissented and asked to be paid fair value. Thedissenting shareholders asserted that fair valueamounted to $642.50 per share once compensationfor an oppressive transfer pricing scheme (that hadbeen in place since 1966) was taken into account.

OMERS' most fundamental complaint was that theFord transfer pricing scheme caused Ford Canada tolose money every year between 1977 and 1995. Noarm's-length business would have tolerated suchlosses without (1) re-negotiating its transfer pricearrangements or (2) going out of business.

Intercompany Transfer Pricing IssuesThe main transfer pricing issues involved design anddevelopment expenses. In the automobile industry,these expenses can amount to billions of dollars fora single model.

Ford's policy was to allocate these expenses rateablybetween its Canadian and U.S. operations based onthe number of cars sold, regardless of the model ofcar being sold.

This policy disadvantaged Ford Canada becausethe Canadian market favored less expensive models,while the U.S. market favored higher end models.The design and development expenses that FordCanada paid to Ford U.S. amounted to billions ofdollars over the 19-year period that Ford Canadasustained losses.

Uniform Selling PricesIn addition to design and development expenses,Ford administered a price parity policy. Under thispolicy, the prices at which Ford sold its products todealers were based in U.S. dollars and were thesame in Canada and the U.S. Those prices, as wellas the prices at which Ford Canada could sell todealers, were set by Ford U.S.

This meant that Ford Canada often had to sell itsproducts to dealers at a loss. This Ford policydiffered from the pricing policies of otherautomobile manufacturers. Other automobilemanufacturers took Canadian market conditions intoaccount when establishing product pricing.



The Court’s DecisionThe Court found that, far from being anarm's-length arrangement, the transfer pricingsystem showed that Ford U.S. treated FordCanada as a wholly owned subsidiary. This wasbecause the effect of the system was tounderstate profits or overstate losses from theCanadian market for Ford Canada.4

Ford U.S. would profit at the expense ofFord Canada, as the higher price of Ford U.S.vehicles could not be passed on to Canadiandealers. This policy would result in a loss toFord Canada. Therefore, Ford U.S. bore 94percent of the losses from Ford Canada. Thisis because Ford U.S. owned 94 percent of theshares of Ford Canada.

However, Ford U.S. accrued 100 percent ofthe profits. And, the minority shareholders ofFord Canada could never recoup their 6percent of the loss. Indirectly, there was animplicit transfer of money from the minorityCanadian shareholders to Ford U.S.

The fact that the transfer pricingarrangements had passed muster with bothU.S. and Canadian tax authorities wasirrelevant to the determination about theirpropriety between shareholders. This isbecause transfer pricing arrangements aregoverned by different standards for income taxpurposes than they are for assessing fairness tominority shareholders.

Shareholder OppressionThe Court found that Ford Canada hadoppressed its minority shareholders bycontinuing to acquiesce to the intercompanytransfer price system. He set the fair value ofthe shares in accordance with the OMERSvaluation, but he limited recovery by applyingthe oppression remedy restrictively.

Justice Cumming first found that a fair valueproceeding under the dissent and appraisalremedy did not exclude a claim for oppression.The rights of dissent and appraisal areexpressly subject to the right to bring anoppression claim. The rights of dissent andappraisal are, under the statute, in addition toany other right the shareholder may have.

Shareholder DamagesRather than awarding damages for the entireamount of the oppression caused by thetransfer pricing, Justice Cumming pro-ratedthe damage over a number of years. Thejudge awarded each shareholder a damageamount on account of only those years thatthe various applicants were shareholders.

In the Court's view, the oppression remedyis "protective of reasonable expectations ofshareholders." Since a shareholder'sreasonable expectations come into existenceonly when they purchase shares, a dissentingshareholder may make a claim for oppressiononly from the date he or she acquiredshares.5

While attractive on one level, the reasoninggoes against accepted case law in Canada.That judicial precedent allowed shareholdersto make oppression claims (1) even if theoppression arose before they becameshareholders and (2) even if the shareholderspurchased shares with knowledge of theoppression or for the purpose of bringing anoppression claim.

Judicial PrecedentJustice Cumming distinguished some of thesecases on the basis that they were derivativeclaims in which the applicant was steppinginto the shoes of the corporation. Since thecorporation could always maintain a claim forwrongs done to it regardless of who itsshareholders were, share ownership at thetime of the wrong was irrelevant.

A more troublesome case for JusticeCumming to distinguish was Palmer v. CarlingO'Keefe.6 It involved an attack on a related-party transaction. The claim was brought byshareholders who purchased shares withknowledge of the pending transaction and forthe specific purpose of bringing the claim toattack the transaction.

Justice Cumming distinguished Palmer onthe basis that the shareholders (1) purchasedbefore the transaction had occurred andtherefore (2) had a right to complain aboutwhat was occurring during the course of theirshareholding.



What is especially noteworthy about Palmer is thatit specifically addresses the point of someone whopurchases with knowledge of the oppression. Palmerholds that such shareholders are not precludedfrom complaining and seeking damages. This isbecause they (1) are simply appreciating what rightsrun with the shares and (2) are purchasing either(a) with the value of those rights reflected in thepurchase price or (b) with the risk of not achievingthose rights reflected in a discount in the purchaseprice.

Justice Cumming seems to have been persuaded todistinguish Palmer because the statute also permitsactions by former shareholders. Unless claims arelimited to oppression that occurred while theapplicant was a shareholder, the possibility of aclaim by former shareholders could result inmultiple, duplicative damages for the same conduct:a multiple limited only by the number ofsubsequent shareholders.7

In Justice Cumming's view, damages foroppression should remain with the person who hassuffered the loss, that is, the shareholders at thetime the oppression occurred. Those shareholderseither (1) sold their shares at a discount or (2)continue to hold the shares with an unrealized loss.8

The Limitations ActJustice Cumming further limited the application ofthe oppression remedy by applying the LimitationsAct to restrict the claim of the minorityshareholders. He held that the claim ought to havebeen discovered by 1984.

By that time, financial analysts were aware of theoverall effect of the transfer pricing policies, if notthe individual details of it. This conclusion also runsagainst the grain of most case law on limitations.

Most limitations cases hold that the plaintiff mustbe aware of the material facts to support a claimfor the limitations period to begin running.Knowing the effect of a transfer pricing policy isnot necessarily the same as knowing that one has alegitimate complaint about it. The effect of applyingthe limitations statute was to restrict the plaintiff'sclaim for oppression damages to the consequencesof the transfer pricing policy for one year.

In addition to awarding limited damages for pasttransfer pricing issues, Justice Cumming dealt withthe impact of transfer pricing on the forward-



Markus Koehnen is a litigation partner at McMillan

Binch LLP in Toronto. He practices extensively in the

area of shareholder litigation and arbitration, class

actions, and complex commercial litigation. He is the

author of Oppression and Related Remedies, a text

dealing with shareholder and corporate governance

litigation to be published by Carswell (the Canadian

division of Westlaw) in June 2004. He has also co-

authored the Canadian chapter in Arbitration World

(London: European Lawyer, 2004), a cross-jurisdictional

text on the law of international arbitration. Markus can

be reached at (416) 865-7218 or at

[email protected].

Reprinted with permission from the Summer 2004 issue

of Willamette Management Associates Insights,

copyright 2004, Willamette Management Associates.

looking valuation by considering Ford Canada as anintegral part of Ford U.S., rather than on a stand-alone basis.

Justice Cumming then determined that FordCanada's fixed assets accounted for 13.88 percent ofFord's consolidated fixed assets of the American andCanadian operations; and he allocated profit andloss of the consolidated operation accordingly.

Summary and ConclusionFord is currently under appeal. If upheld, it is likelyto have a chilling effect on oppression claims byinstitutional investors in Canada.

The conclusion implicit in Ford, that rights attachto shareholders rather than to shares, significantlylimits the value of oppression claims in the publiccompany context. Its analysis on limitations issues-based on the effect of policies rather than on anunderstanding of their underlying factual elements-further restricts the economic value of shareholderclaims.

However, Ford also serves as a warning to investorsto speak up when faced with undesirable effects.

Notes:1. Mr. Koehnen would like to thank Adrienne Lee,

a litigation associate with McMillan Binch, for herinvaluable assistance in preparing this article.

2. [2004] O.J. No. 191 (S.C.J.), Cumming J. para. 98, 142, 143, 151 [hereinafter Ford].

3. Standing extends beyond shareholders to directors, officers, or any other person the court deems appropriate to make an application.

4. Ford, supra, at paras. 349 and 309.

5. Ford, supra, at paras. 231-232.

6. (1989), 67 O.R. (2d) 161 (Div. Ct.) (hereinafter Palmer).

7. Ford, supra, at para. 247.

8. Hordo, supra, at 92.



The Capital Asset Pricing Model (CAPM)stems from Modern Portfolio Theory (MPT)that was developed as a result of a 1952article published by Professor HarryMarkowitz and updated in 1959, and soughtto explain the relationship between risk andreturn in securities portfolios for investors.Markowitz introduced the outlines of asystematic framework for investmentmanagement and showed that an investor'sportfolio choice can be reduced to balancingthe expected return on the portfolio and itsvariance. Variance or variance of return is a"measure of dispersion about the expected,"according to Markowitz. MPT is a risk-premium model that assigns increasinglyhigher returns to increasing risk. Risk isdefined as the covariability of an asset orportfolio returns with the market returns.Portfolio risk is now tied to the interaction ofthe components.

Before MPT, according to many observers,financial analysts, portfolio managers, andinvestors looked at each investmentopportunity as being unique… well not quite.As far back as the Code of Hammurabi,around 1800 B.C. (Hammurabi being a kingin the first dynasty of Babylonia), establishedthe maximum rate of interest that a moneylender or investor might charge a borroweron loans of grain, which was repayable inkind, at 33 1/3 % per annum. On loans ofsilver, the maximum rate was set at 20%.Not much in the way of diversification, butinvestors were being compensated for theincreased risk.

Based on Markowitz's work, ProfessorWilliam Sharpe, in the mid-1960s, developed,along with others independently of oneanother, what has become known as theCapital Asset Pricing Model. Markowitz andSharpe, along with Professor Morton Miller,shared the Nobel Prize in Economic Sciencesin 1960. Sharpe's paper entitled "CapitalAsset Prices: A Theory of Market

Equilibrium Under Conditions of Risk," wasfinished in 1962 and published in 1964. The modeldefines "risk" as the volatility of a security’s returnsto that of the market.

I believe that herein lies one of the problems inusing the CAPM – at least in business appraisals."Risk" is exposure to possible loss or injury. It is adanger, a hazard, a gamble. If a stock price goesup more or less than the market index in the shortterm, where is the risk? If the momentum carriesthe stock down more than the index, where is therisk? Is it that the investor has a short time horizonand may wish to sell at the very time the marketdeclines? Investors have always known that moneyin the market is at risk and stocks fluctuate. Evenan excellent long-term investment may be a disasterif the holding period is too short. As mostprivately-owned companies are held for the longpull, shouldn't appraisers have a better definition ofrisk? Expected returns and risk are the mainstaysof a portfolio according to Markowitz. Expectedreturn relates to the expected return of the index,but risk is more complicated. It relates to the risksof the individual components of the portfolio andthe correlation.

The CAPM defines risk as the covariability of thesecurity's returns with the market returns. The riskthat can be eliminated is called "nonsystematic" or"non-market-related," because it is caused bychanges that are specific to the company issuing thesecurity. Risks associated with individual firms canbe diversified away. The systematic risk is the riskassociated with the market and can not bediversified away. The CAPM designates systematicrisk as Beta, which stands for the volatility of anasset or portfolio relative to that of the market.Already we have additional problems. The Beta isbased on historical results of asset behavior andmay not be predicable of the future. Forecasts offuture volatility are hard to make and to validate.Moreover, it is possible that systematic risk or Betais too limited to define a security's risk. It certainlyis when it comes to valuing the privately-ownedcompany as it ignores the specific business risks ofthe business interest under appraisal.

BY JAMES H. SCHILT ASA, CBA, CFA CAPM and Business Valuation

In a January 2004 draft of a working paperentitled "The Capital Asset Principal Model:Theory and Evidence," Fama and Frenchstate that "in the late 1970s, research beginsto uncover variables like size, various priceratios, and momentum that add to theexplanation of average returns provided byBeta. The problems are serious enough toinvalidate most applications of the CAPM."

Many authors in the field of businessvaluation provide excellent explanations ofthe working of the CAPM. (See References.)Jay Fishman does a particularly good job inbringing together the build-up method andthe CAPM method along with the use ofguideline companies for business appraisersin Section 503 in the 2003 Edition of Guide toBusiness Valuation. Other author/appraisers inthe cautious group regarding use of theCAPM would include Ian Campbell andGeorge Hawkins.

It is my belief, however, that there stillremains a large leap of faith between the useof Beta in the management of securityportfolios and the appraisal of closely-heldbusiness interests in spite of severalauthoritative authors who warn about its use.Could it be the problem with the Emperor'snew clothes that such a large group ofappraisers don't see it?1 In a recentlypublished informative article in The ValuationExaminer, Michael Elmaleh states that "If therisk/return model cannot accurately predictthe price movement of publicly tradedequities, where the ability to measure riskand future income is relatively good, whywould you expect the model to yield accuratepredictions about the price of closely heldequities, where the ability to measure riskand future income is generally much worse?"

My own research on the subject has beenpublished in Business Valuation ReviewSeptember 1991, December 1994, March2000 and December 2003. The data wastaken from Value Line Investment Survey goingback to 1986 and showed changes in Betaand safety ratings at three to five yearintervals. For the original article, I randomlyselected ten industries and took the first

The CAPM assumes that:

! The investor is risk adverse with an objective to maximize his terminal wealth.

! Investors have diversified portfolios.

! There are no taxes or transaction costs.

! All investors have identical time horizons.

! All investors have identical perceptions regarding the expected returns, volatilities and correlations of available risky investments.

In the real world this is not the case, butappraisers have made many leaps of faith when itcomes to the CAPM and its use in businessvaluation. Another difficulty is that different Betasare reported by different Beta services, and they canvary widely. The length of time over which onecalculates a Beta is important as they changesignificantly as the period changes. To use a Beta tomeasure the "risk" in an individual private company,one should use a Beta that arises from the results ofa group of publicly-traded stocks that representfirms that are similar to the company underappraisal, then, for simplicity, you might select themedian average Beta of the guideline companies.But how many companies are you going to findwith similar product lines, size, operating andfinancial ratios, depth of management, anddiversification? Dr. Rolf Barry in 1981, then withAlliance Capital in London, found that during the1936-75 period, the average return to stocks ofsmall firms (those with low values of market equity)was substantially higher than the average return tostocks of large firms after adjusting for risk usingthe CAPM. In 1992, Professors Eugene Fama andKenneth French found the same thing as regards tosize in addition to the ratio of book value of a firm'scommon equity to its market value as an explanatoryvariable. In fact, book-to-market equity appears tobe more powerful than size. Fama and French usedstock returns for 1963-90. However, it should bepointed out, when they ran their regressions for1941-65, they found a positive relationship betweenaverage return and Beta. As Sharpe said in aninterview taken from the Dow Jones Asset Manager,May/June 1998, "In the data it's hard to find astrong, statistical significant relationship betweenmeasured betas and average returns of individualstocks in a given market." We know that amplitudeof future stock market movements cannot beforecast by basic regression technique.





seven stocks that were reviewed by ValueLine. From the original 70, there remained31 in the final Survey due primarily tocompanies having been acquired or loweredinvestment interest.

Value Line uses the term "Safety" ratherthan "Risk." Safety incorporates the financesof each company in addition to volatilitywhich means a better look at "risk" of abusiness enterprise than just the volatility ofa security's return in the CAPM model. Thedata disclosed that most of the stocks underexamination failed to show any change inrisk as defined by Value Line, while the Betachanged in almost every case. This shouldnot be a surprise since the Beta coefficient isa measure of the "variance of return" andnot a quality rating.

As suggested by Diana Harrington in herbook on MPT and CAPM, "The definition ofrisk as relative volatility of returns has somedisadvantages, however. First, forecasts offuture volatility are difficult to make and toverify. Second, it is possible that systematicrisk or beta is too limited a definition of asecurity's risk."

In addition to the use of a Beta, manyappraisers will apply an additional discountrate to cover company-specific business risksas they realize that ownership of a privately-held business has much greater risk than aportfolio investment. The question remainsas to why use a Beta at all in the valuationof a single, privately-owned long term equityinvestment? Beta does not say anythingabout the business entity. It is simply a merecomputation using historical data of marketand stock prices! Apparently, too manybusiness appraisers live in a world wherefantasy has more status than reality. Readersshould take heart. Even without the CAPM,there are some wise men who know aboutinvesting besides the sage of Omaha. WillRogers, for example, wrote some goodadvice:

Don't gamble; take all your savings and buysome good stock, and hold it till it goes up,then sell it. If it don't go up, don't buy it.

Endnote1. The Emperor's New Clothes comes from a fable by Hans

Christian Andersen. In it, a foolish Emperor is convinced he has bought an enchanted wardrobe of lightweight garments from two con men, that are invisible to him, but are seen by his subjects as elegant royal costumes, heavily brocaded with gold and silver threads. None of the sycophants around the Emperor dared tell him the truth. One day, as the Emperor was out in public displaying his finery, a child among the spectators, too young to know howto lie, cried out for all to hear, "Look. He's naked. Thatguy in the crown is naked."

ReferencesBarry, R., "The Relationship Between Return and Market

Value of Common Stocks," Journal of Financial Economics9, March 1981, pp. 3-18.

Campbell, J. and H. Johnson, The Valuation of Business Interests, Toronto: Canadian Institute of Chartered Accountants, 2001.

Elmaleh, M., "What Do the Ibbotson Historical Studies Really Prove About Firm Size, Risk and Return?" The Valuation Examiner, January/February 2004, pp. 9-11.

Fama, E. and K. French, "The Cross-Section Of ExpectedStock Returns," Journal of Finance 47, June 1992, pp. 427-65.

"Common Risk Factors in the Returns on Bonds and Stocks," Journal of Financial Economics 33, February 1993, pp. 3-56.

"The Capital Asset Pricing Model: Theory and Evidence,"Unpublished Paper, January 2004.

Fishman, J., S. Pratt, J. Cliffith and D. Wilson, Guide to Business Valuation, Forth Worth: Practioners Publishing Co., 2003.

Harrington, D., Modern Portfolio Theory and the Capital AssetPricing Model, Englewood Clifts, N.J.: Prentice-Hall, 1983.

Hawkins, G. and M. Paschall, CCH Business Valuation Guide, Chicago: CCH Incorporated, 2003.

Kasper, L., Business Valuation: Advanced Topics, Westport, Conn.: Quorum Books, 1997.

Markowitz, H., "Portfolio Selection," Journal of Finance, March 1952, pp. 77-91.

Mercer, Z.C., Quantifying Marketability Discounts, Memphis:Peabody Publishing, 1997.

"The Adjusted Capital Asset Pricing Model for Developing Capitalization Rates," Business Valuation Review, December 1989, pp. 147-156.



Pratt, S. Cost of Capital, New York: John Wiley & Sons, Inc., 1998.

Schilt, J., "Alpha Comes Before Beta," Business Valuation Review, September 1991, pp. 116-120.

"Another Look at Betas," Business Valuation Review, March1995, pp. 22-25.

"Still Another Look at Betas," Business Valuation Review, March 2000, pp. 16-18.

"Bye, Bye Betas," Business Valuation Review, December 2003, pp. 168-171.

Sharpe, W., "Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk," Journal of Financial Economics, 19.3 (1964) pp. 425-442.

AddendumAfter submitting the foregoing paper forpublication, I received the March/April 2004 issueof the Financial Analyst Journal (published by theAssociation for Investment Management andResearch), which included some comments onvaluation that should be of interest. The article inquestion entitled "Value at Risk and Expected StockReturns," by Professors Bali and Cakici states thefollowing:

The primary implication of the capital asset pricingmodel (CAPM) of Sharpe (1964), Lintner (1965),and Black (1972) is that a positive linearrelationship exists between expected returns onsecurities and their market betas and thus variablesother than beta should not capture the cross-sectionalvariation in expected returns. Over the past twodecades, many researchers have found thatidiosyncratic factors, such as stock size, book valueof equity to market value of equity (BE/ME), andthe earnings-to-price ratio have significantexplanatory power for average stock returns but thatbeta has little or no explanatory power at theindividual-stock level.

It should be remembered that the CAPM wasdesigned for application, among other uses, byfinancial analysts in constructing a portfolio ofstocks. When the instructors of core users begin toabandon the method it is a bad sign. Where doesthis leave the business appraiser who uses themodel?

James Schilt was a charter member and vice chairman

of ASA's Business Valuation Committee and is Editor

Emeritus of Business Valuation Review. He attended

California, Stanford and Cambridge Universities and is

an independent business appraiser and forensic

consultant in San Francisco.

This article is printed with permission of the Business

Valuation Review, a publication of the American Society

of Appraisers. It was originally published in the March

2004 edition of the Business Valuation Review.

percent. (On the one hand, this assumption mightbe quite heroic for actively managed equity fundsthat generate short-term gains. On the other hand,the effective capital gains tax could be reduced bydeferred realization, charitable contributions – ordemise.1 ) On an after-tax basis, this 20 percent taxtakes the 7 percent equity return down to 5.60percent (see Table 2). But now, if the taxable risk-free rate is used as a base, with its 2.40 percentafter-tax yield, the after-tax premium rises to 3.20percent (i.e., somewhat higher than the originalpretax premium of 3.00 percent). Thus, the taxableinvestment actually receives a somewhat greatercompensation on a spread basis for accepting equityrisk. On a percentage basis relative to the risk-freerate, the taxed investor's 133 percent ratio (3.20percent/2.40 percent) looks a lot better than thetax-free 75 percent. (A simple calculation can showthat, even if the pretax risk premium were zero,these tax effects would produce a positive after-taxpremium of 0.80 percent.)



The literature on taxable investing appearsto have overlooked the way in whichdifferent tax rates can lead to equity riskpremiums that are actually greater than theoriginal tax-free premiums. Moreover, thistax-based enhancement can occur in both anominal and a real (after-inflation)framework. With the imminence of a newtax regime (at least for a few years), it ishigh time to revisit the nature of thispremium enhancement, especially in light ofthe striking implications of the enhancementfor asset allocation.

First, consider the interaction of taxes andinflation on a fixed-income investment.Suppose the long-term risk-free rate is 4percent, made up of a 3 percent real rateand a 1 percent inflation expectation – allpretax. Now consider the situation of ahypothetical investor who faces a tax rate of40 percent on interest income (rememberstate taxes). Applying the 40 percent tax rateas shown in Table 1 reduces the after-taxreturn on the risk-free rate to 2.40 percent –but the after-inflation after-tax rate-the "realafter-tax" rate – is only 1.40 percent. Now, itis well known that a low risk-free rate leadsto low real after-tax rates. What is not wellknown is that higher inflation rates lead toeven lower real after-tax rates. For example,if expected inflation were to rise to 5percent, the resulting 8 percent pretaxnominal rate would then produce a nominalafter-tax return of 4.80 percent but a realafter-tax return of -0.20 percent.

Put aside the inflation question for themoment and, turning to equities, focus onnominal returns. Suppose the pretax riskpremium is fixed at 3 percent so that withthe interest rate at 4 percent, the pretaxequity return is 7 percent. Note that the 3percent risk premium corresponds to 75percent of the interest rate. Now, assumethat all equity returns are taxed at 20

BY MARTIN L. LEIBOWITZ The Higher Equity Risk PremiumCreated by Taxation

Table 1. Nominal and Real After-Tax Interest Rates: Different Expected Inflation Rates

1 Percent 5 PercentMeasure Inflation Rate Inflation Rate

Real pretax interest rate 3.00% 3.00%Expected inflation rate + 1.00 + 5.00Nominal pretax interest rate 4.00% 8.00%Tax effect @ 40 percent ! x 0.60 ! x 0.60Nominal after-tax interest rate 2.40% 4.80%Inflation rate - 1.00 - 5.00Real after-tax interest rate 1.40% - 0.20%

Table 2. Nominal After-Tax Equity Risk Premium: Different Nominal Pretax Interest Rates

4 Percent 8 PercentNominal NominalPretax Pretax

Measure Interest Rate Interest Rate

Nominal pretax interest rate 4.00% 8.00%Expected pretax risk premium + 3.00 + 3.00Nominal pretax equity return 7.00% 11.00%Tax effect @ 20 percent ! x 0.80 ! x 0.80Nominal after-tax equity return 5.60% 8.80%Less nominal after-tax interest

rate - 2.40 - 4.80Nominal after-tax risk premium 3.20% 4.00%



One of the key factors enhancing the after-taxpremium is how equity's tax advantage is brought tobear on the underlying risk-free rate. The same 4percent risk-free rate is taxed at 40 percent as astand-alone fixed-income investment but at afavorable 20 percent rate when it is embedded in anequity investment. In essence, the equity structureprojects its "tax shield" onto the fixed-incomeinvestment that forms the theoretical foundationbeneath the equity risk premium. Because this taxadvantage increases with higher interest rates, thesomewhat surprising result (shown in the secondcolumn of Table 2) is that the after-tax riskpremium also rises with increases in the nominalpretax risk-free rate. Of course, if the equity returnin an after-tax context is contrasted with amunicipal risk-free rate, the shift in the riskpremium will depend on the municipal-to-taxableyield ratio.

The taxable equity investment has anotheradvantage over the tax-free investment: Itsafter-tax volatility may be lower. Becauselong-term gains are taxed and losses can actas tax offsets, the taxable investor mayexperience a net after-tax price volatility thatis only 80 percent of the literal marketvolatility. If so, the after-tax equity premiumof 3.20 percent in the preceding examplecorresponds to a lower equity volatility thanin the pretax situation. Thus, with the riskpremium viewed as compensation forvolatility risk, the after-tax situation providesa higher risk premium for a lower level ofvolatility. In other words, the after-taxpremium compensation per unit of volatilityrisk is much higher than in the tax-freecase. To properly compare the risk premiumin the two cases, the after-tax equity positionmust be notionally levered up (or the equityallocation augmented) so that the volatilityrisks are matched. The resulting enhancedafter-tax risk premium will then be "riskcomparable" to the pretax premium. (Thisvolatility-match argument also applies whenmunicipals are taken for the risk-free rate inthe taxable context.) A 25 percent leveragingdrives the total equity volatility from 80percent up to 100 percent of the tax-freevolatility. As shown in Table 3, with theafter-tax volatility levered up by this 25percent factor, the effective after-taxpremium rises from 3.20 percent to 4.00percent – a full 1 percentage point greaterthan the original pretax premium of 3.00percent.

Now, what about the inflation effect on theequity risk premium? Prior to the volatilityadjustment, the nominal equity return was5.60 percent for the case of an expected 1percent inflation (Table 2). This rate reducesthe real after-tax equity return to 4.60percent, just as it reduces the risk-free rateto 1.40 percent. But the basic risk premiumremains unaffected at 3.20 percent becausethe risk-free rate has already "absorbed" theinflation wedge. Thus, as Table 4 shows, theafter-tax premiums will always retain thesame value on both a nominal and a real

Table 3. Volatility-Matched Nominal After-Tax Equity Risk Premium: Different Nominal Pretax Interest Rates

4 Percent 8 PercentNominal NominalPretax Pretax

Measure Interest Rate Interest Rate

Nominal pretax interest rate 4.00% 8.00%After-tax volatility as percentage

of pretax volatility (20 percentequity tax rate) 80.00% 80.00%

Leveraging required to matchafter-tax to pretax volatility(100/80 =) 1.25 1.25

Nominal after-tax premium(from Table 2) ! x 3.20% ! x 4.00%

Volatility-matched nominalafter-tax premium 4.00% 5.00%

Nominal after-tax interest rate(from Table 2) + 2.40 + 4.80

Volatility-matched nominalafter-tax equity return 6.40% 9.80%

Table 4. Real After-Tax Equity Premium:Different Expected Inflation Rates


Expected inflation 1.00% 5.00%Nominal after-tax equity

return (from Table 2) 5.60% 8.80%Less inflation effect - 1.00 - 5.00Real after-tax equity return 4.60% 3.80%Less real after-tax interest rate

(from Table 1) - 1.40 - (-0.20)Real after-tax risk premium 3.20% 4.00%

basis. For the same reason, the volatility-matched after-tax premiums also remain un-changed by the prospect of expectedinflation, as Table 5 demonstrates.

Bringing all these results together, Table 6shows that for the case of 1 percentinflation, the risk premium goes from 3percent on a nominal pretax basis to 3.20percent after taxes and then remains at 3.20percent on a real after-tax basis (i.e., bothbefore and after expected inflation). On avolatility-matched basis, the after-taxpremium rises to 4.00 percent (again on botha real and a nominal basis). In contrast, theinterest rate declines from 4.00 percentpretax to 2.40 percent after-tax and then to1.40 percent on a real after-tax basis. As apercentage of the interest rate, the riskpremium rises from 75 percent on a nominalpretax basis to 286 percent on a volatility-matched real after-tax basis.

At the more severe inflation level of 5percent, Table 6 shows that the interest rateon an after-tax basis drops even farther thanin the case of 1 percent inflation – from an



8.00 percent nominal pretax rate down to theslightly negative value, -0.20 percent, on a realafter-tax basis. At the same time, the volatility-matched after-tax premium rises to 5 per-cent fromits nominal pretax value of 3 percent. At first,these results seem to argue that more taxation isbetter, but note that, although the risk premiumincreases, the real after-tax returns shift

Table 5. Volatility-Matched Real After-TaxEquity Risk Premium: DifferentExpected Inflation Rates


Expected inflation 1.00% 5.00%After-tax volatility as percent

pretax volatility given 20percent equity tax rate 80.00% 80.00%

Leveraging required to matchafter-tax to pretax volatility(100/80 =) 1.25 1.25

Real after-tax premium (fromTable 4) ! x 3.20% ! x 4.00%

Volatility-matched real after-taxpremium 4.00% 5.00%

Real after-tax interest rate(from Table 1) + 1.40 + (-0.20)

Volatility-matched real after-taxequity return 5.40% 4.80%

Table 6. Equity Risk Premium Relative to Corresponding Interest Rates: Different Expected InflationRates

1 Percent Inflation Rate 5 Percent Inflation Rate

Table As Spread As Percent As Spread As PercentSupplying over Interest of Interest over Interest of Interest

Expected Inflation Data Return Rate Rate Return Rate Rate

Nominal pretax equity return 7.00% 11.00%Nominal pretax interest rate 4.00 8.00Nominal pretax premium 3.00% -1.00% 75% 3.00% -5.00% 38%

Nominal after-tax equity return 2 5.60% 8.80%Nominal after-tax interest rate 1 2.40 4.80Nominal after-tax premium 2 3.20% +0.80 133 4.00% -0.80 83

Volatility-matched nominal after-taxequity return 3 6.40% 9.80%

Nominal after-tax interest rate 1 2.40 4.80Volatility-matched nominal after-tax

premium 3 4.00 +1.60 167 5.00% 0.20 104

Real after-tax equity return 4 4.60% 3.80%Real after-tax interest rate 1 1.40 (0.20)Real after-tax premium 4 3.20% +1.80 229 4.00% +4.20 na

Volatility-matched real after-taxequity return 5 5.40% 4.80%

Real after-tax interest rate 1 1.40 (0.20)Volatility-matched real after-tax

premium 5 4.00% +2.60% 286% 5.00% + 5.20% na

na = not applicable.


Note1. For an excellent discussion of the effective tax

rates that can apply to various investments under various tax regimes, see Arnott, Berkin, and Ye (2000), Bodie and Crane (1997), Dybvig and Ross (1986), Scholes, Wolfson, Erickson, May-dew, and Shevlin (2002), and Shoven and Sialm (2000), among others.

ReferencesArnott, R.D., A.L. Berkin, and J. Ye. 2000. "How Well Have Taxable Investors Been Served in the 1980s and1990s?" Journal of Portfolio Management, vol. 26, no. 4(Summer):84-93.

Balcer, Y., and K.L. Judd. 1987. "Effects of Capital GainsTaxation on Life-Cycle Investment and PortfolioManagement." Journal of Finance, vol. 42, no. 3(July):743-758.

Bergstresser, D., and J. Poterba. 2000. "Do After-Tax Returns Affect Mutual Fund Inflows?" National Bureauof Economic Research Working Paper 7595.

Bodie, Z., and D.B. Crane. 1997. "Personal Investing: Advice, Theory, and Evidence." Financial Analysts Journal,vol. 53, no. 6 (November/December):13-23.

Dammon, R.M., and C.S. Spatt. 1996. "The Optimal Trading and Pricing of Securities with AsymmetricCapital Gains Taxes and Transaction Costs." Review ofFinancial Studies, vol. 9, no. 3 (Fall):921-952.

Dammon, R., C. Spatt, and H. Zhang. 2000. "Optimal Asset Location and Allocation with Taxable and Tax-Deferred Investing." Unpublished paper, Carnegie-MellonUniversity.

Dybvig, P.H., and S.A. Ross. 1986. "Tax Clienteles and Asset Pricing." Journal of Finance, vol. 41, no. 3(July):751-762.

Protopapadakis, A. 1983. "Some Direct Evidence on Effective Capital Gains Tax Rates." Journal of Business, vol.56, no. 2 (April):127-138.

Scholes, M.S., M.A. Wolfson, M. Erickson, E.L. Maydew, and Terry Shevlin. 2002. Taxes and Business Strategy. 2nded. Upper Saddle River, NJ: Prentice-Hall.

Shoven, J.B., and C. Sialm. 2000. "Asset Location for Retirement Savers," National Bureau of EconomicResearch Working Paper 7991 (November).

Tepper, I. 1981. "Taxation and Corporate Pension Policy."Journal of Finance, vol. 36, no. 1 (March):1-13.

Martin L. Leibowitz is Vice Chairman and ChiefInvestment Officer at TIAA-CREF, New York City.

Copyright 2003, CFA Institute. Reproduced andrepublished from Financial Analysts Journal withpermission from CFA Institute. All Rights Reserved.


significantly downward, from 8.00 percent to -0.20per-cent for fixed income and from 11.00 percentto 4.80 percent for equities.

What do these results imply for asset allocation?In essence, all that this work has done is to quantifythe well-known tax advantage afforded to long-termcapital gains (an advantage that recently has beenenhanced and also extended to some dividends).This quantification does suggest, however, that if agiven mean-variance allocation is derived in a tax-free framework (and if risk tolerances arecomparable), then a somewhat higher equityallocation will be obtained in a taxable context thanin the tax-free context. This assumption of equalrisk tolerances may be a stretch, however, especiallygiven that tax-free institutions typically have longertime horizons and stronger standby resources thantaxed individuals. Another confounding issue is thatthe symmetrical character of a mean – varianceoptimization might not fully capture a taxedinvestor's aversion to the more severe shortfallprospects associated with the tax and inflation-driven downward shift in the overall pattern ofreturns. And finally, there is the question of theconditions that would tip a taxed portfolio toward amore significant allocation to tax-exempt bonds.

Although being taxed brings little joy, investorsand investment managers should recognize theapparently higher compensation for accepting long-term equity risk. This incremental risk premiummay provide, in some circumstances, a smallmodicum of comfort.

The author would like to express his deep gratitude to Brett

Hammond for his help at many levels in the development of this

article and to Peter L. Bernstein, Stanley Kogelman, David F.

Swensen, and Jack L. Treynor for their valuable and insightful

suggestions. This article focuses on basic concepts of financial

theory and should not be construed as reflecting the official

position of TIAA-CREF. The author is not a tax expert, and

the information here should not be viewed as tax or legal advice.

The computations shown are for illustrative purposes only and

use tax rates intended to simplify calculations. Actual rates may

vary.

DIGEST - CBV InstituteRisk Premium Created by Taxation . . . . . .18 The Business Valuation Digest...

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