Introduction to Fairness Opinions
A fairness opinion is an opinion as to whether a proposed transaction is fair from a financial point of view. A fairness opinion is usually provided on behalf of either the buyer or the seller of a proposed transaction. In some cases, a fairness opinion is provided on behalf of both parties to a transaction.
When a fairness opinion is provided on behalf of either a buyer or a seller, the fairness opinion typically 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 generally addresses only the fairness of the price of a transaction and does not comment on other terms of the deal, such as the legal aspects of the deal.
It is important to understand what a fairness opinion is not. A fairness opinion is not a recommendation on whether to pursue a deal. A fairness opinion is also not an estimate of the proper consideration to be paid in a deal.
In rare cases, a fairness opinion does not only opine on the fairness of the price of the deal but also opines on the fairness of the transaction as a whole.
Fairness opinions are typically sought by advisors to a party of a prospective transaction. A fairness opinion is most often obtained by a group of independent directors of a company in a proposed transaction. (These directors are often called a "special committee of the board of directors.") The audience for a fairness opinion typically includes the entire board of directors (including the independent directors) and the owners of the company.
There are two common forms of fairness opinions. The first, a fairness opinion presentation, is typically a preliminary presentation made to the directors of the company. This presentation will typically include: (1) a transaction summary, including a point-in-time situation analysis of the company, the counterparty, and the market as a backdrop for the contemplated transaction; (2) the scope of work performed, including significant assumptions or conditions and the limitations of the analysis, including any limitations on use; (3) a description of interviews with senior management; and (4) the valuation analyses of the company and/or the transaction.
The second form of fairness opinion is the formal fairness opinion letter. A fairness opinion letter is a relatively short document (typically only a few pages) that summarizes the engagement and the tasks and analyses performed and then states whether the deal is fair from a financial point of view.
Fairness Opinion Background
The fairness opinion as we know it today has been around for approximately 20 years. In the case of Smith v. Van Gorkum, the board of Trans Union Corporation was found to have breached their fiduciary duty of care by approving a merger without obtaining or considering a thorough financial analysis of the intrinsic value of the company. It has since become common practice for persons with fiduciary duty to obtain a fairness opinion as proof that they have performed their fiduciary duty in analyzing a prospective deal from a financial standpoint.
It is commonly believed that a fairness opinion would have provided evidence that the Trans Union board had acted in a firm manner and had discharged its duty of care. The duty of care requires that fiduciaries act on an informed basis after careful deliberation and that they exercise the care than an ordinary prudent person would exercise under similar circumstances.
Differences Between a Fairness Opinion and a Valuation
While valuation analyses typically form the core of a fairness opinion, there are significant differences between the two.
A fairness opinion is not a conclusion or an opinion as to the value of a security or a company. It is well established that those of us who practice in the valuation profession do not calculate what the value of a security is. Instead, we provide an estimate or an opinion as to value. In many cases, a valuation conclusion is expressed as a range of values.
A fairness opinion, on the other hand, does not conclude to a value or even to a range of values. The different valuation analyses contained in a fairness opinion are each presented on a stand-alone basis; no attempt is made to weight the different analyses or to present a single value conclusion. That said, in reality, the parties to a fairness opinion will often place the greatest weight on the income-approach valuation analyses (such as discounted cash-flow analyses).
A fairness opinion looks at the value of interests received as compared to the value of interests given up. A fairness opinion does not determine value but tests and validates a prospective transaction price or merger exchange ratio.
A positive fairness opinion does not indicate that the deal price is the best possible price for the buyer or seller. A positive fairness opinion merely opines that that proposed price is either (1) within the range of possible fair deal prices, (2) higher than the range of possible fair deal prices from the prospective of the sellers, or (3) lower than the range of possible fair deal prices from the perspective of the buyers.
The valuation analyses performed for a fairness opinion are similar to those performed for a valuation assignment. However, the fairness opinion valuation analyses might have specific requirements that affect the valuation analyses performed. For example, in some cases, the fairness opinion for a transaction of a minority interest in a company should not consider certain valuation discounts (such as discounts for lack of control and lack of marketability) that might be applied in an otherwise-similar valuation assignment.
A valuation performed for a fairness opinion as opposed to a valuation assignment might also differ in the application of certain valuation variables, including normalization adjustments, cost of capital, capital structure, tax issues, and management incentives.
Another important difference between a valuation and a fairness opinion is that in a typical valuation, the value estimate reflects the price that would take place between a hypothetical willing buyer and a hypothetical willing seller. This contrasts with any situation involving a fairness opinion, where the identity of both the buyer and seller are most certainly known. The fairness opinion provider will inevitably and necessarily consider attributes of the specific parties to the transaction in analyzing whether the transaction is fair.
Finally, a fairness opinion must consider the acquisition premium (an issue that doesn't arise in most valuation assignments). The acquisition premium affects the fairness opinion in several ways. The value of synergies—and the allocation of the value of the synergies between the parties to a transaction—is an important factor that might be determined by negotiating power and ability as much as by valuation analysis. The analysis of an appropriate acquisition premium might also consider the differences between potential financial buyers and strategic buyers of a company.
The consideration of these factors might result in fairness opinion valuation analyses that reflect the standard of value of investment value, which considers value attributes to a specific owner. This contrasts with the standard of value of fair market value most commonly applied in valuation assignments, where the buyer and seller are both hypothetical, and there is no consideration of attributes specific to any one party.
Another difference between a fairness opinion and a valuation is that, all else equal, the preparation of a fairness opinion involves more work than the preparation of a valuation analysis and/or report. This is because in order to provide a fairness opinion, it is necessary to perform a significant additional-amount-of-background task regarding two or more parties to a transaction (as opposed to one company for a typical valuation assignment). In addition, the fairness opinion provider needs to perform a higher level of diligence because of risk related to the possibility of litigation related to a transaction.
In a valuation assignment, there is little uncertainty as to the valuation date, which is prominently and unambiguously stated in the valuation report. This contrasts with the situation of most fairness opinions, in which the fairness opinion is provided at the time that the deal is announced rather than at the time of the deal closing.
There is often a period of many months between deal announcement and deal closing. Many things can take place during this period. The prospects of one or both parties to the transaction can change significantly. If the prospects of the seller improve significantly and unexpectedly, the company might become more valuable during this period. If the selling shareholders are receiving equity in the purchaser, this can significantly impact the value of the consideration received. In some cases, a fairness opinion provided at the time of the closing (known as a bring-down fairness opinion) is provided.
Despite the aforementioned differences between a fairness opinion and a valuation, it is important to be aware of certain situations where these differences might not matter. When a valuation is provided to a public company (related to the value of either the entire company or of one or more subsidiaries of the company) prior to a transaction involving the valuation subject, the valuation provider has, in one sense, effectively provided a fairness opinion. This is because the results of the valuation analysis (even if these results are only preliminary in nature) will likely be disclosed to shareholders in public filings after the announcement of the deal. A good rule to remember is that if it looks like a fairness opinion, then it effectively is a fairness opinion.
It is therefore critical for both (1) the obtainer of the fairness opinion (such as a committee of independent directors) and (2) the valuation provider to recognize such a situation. For the fairness opinion obtainer, this is an important part of fulfilling fiduciary duty and completing the necessary steps in order to provide proper advice concerning a prospective transaction (as well as to minimize the chances of liability). For the fairness opinion provider, this will ensure that he or she performs the proper amount of work and is properly compensated for a fairness opinion (which requires more work and involves more risk than an otherwise-similar valuation assignment).
The Controversy Surrounding Fairness Opinions
Several studies have suggested that most acquisitions do not ultimately add value for the buyer. In fact, when the judge in the recent New York Stock Exchange merger litigation asked the top-flight attorneys and financial advisors assembled for the NYSE merger hearing whether they were aware of any negative fairness opinions, the response was a resounding "never." While there are many reasons for this apparent contradiction, the fact is that there has always been a certain amount of controversy surrounding fairness opinions.
One of the primary reasons that fairness opinions are so controversial relates to alleged conflicts of interest between fairness opinion providers and the parties to a prospective transaction. In many cases, the investment bank advising the buyer or seller on a prospective deal also provides a fairness opinion supporting the deal. In such a case, there can be a question as to whether the fairness opinion is affected by the fact that the investment bank stands to earn a substantial fee only if the deal is successfully completed.
Even in cases where the investment bank providing a fairness opinion is not directly involved in a prospective deal, many observers believe that a "negative" fairness opinion is unlikely because all investment banks are interested in maximizing the number of completed deals.
In addition, there might be a relationship between the investment bank and the fairness opinion provider that has nothing to do with the subject transaction. For example, consider the recent merger of the New York Stock Exchange with Archipelago Holdings, Inc. In this case, fairness opinions were initially provided by Lazard and Greenhill. However, the deal was initiated by Goldman Sachs, which played a significant role as an advisor to both parties to the transaction and stood to earn fees upon deal completion. At the time of the deal, Goldman Sachs was the investment bank of the pending Lazard initial public offering (IPO) and had previously been involved in the IPO of Greenhill.
Therefore, in the case of investment banks performing fairness opinions, the incentive is to "scratch my back, and I'll scratch yours" or risk being cut off from future deal flow and/or related activities, such as allocations of initial public offerings.
Several other trends have contributed to the increasing controversy surrounding fairness opinions. The Wall Street research scandals of recent years have led to greater scrutiny of investment banking relationships in general, including the relationships between fairness opinion providers and other investment banking advisors.
In addition, the financial press has become more aggressive in highlighting potential conflict-of-interest issues. The business climate today is increasingly litigious. Officers and directors are held to ever-higher standards and have in some cases been hit with personal liability.
Finally, shareholders have become more active and have in some cases fought against the completion of a proposed transaction.
Notwithstanding the above areas of controversy, perhaps the most important controversy surrounds the deal price. As mentioned above, a fairness opinion addresses the issue of whether a deal price is fair but does not address the issue of whether the price represents the best possible deal for the buyer or the seller.
In some cases, selling shareholders may collectively decide that an imperfect deal is better than taking the risk of rejecting a proposed deal with the hope of obtaining a higher price. In other cases, better-informed shareholders might reject—and in some cases have rejected—proposed deals.
A Newer Trend: Private Equity
One recent trend is the increasing number of public companies going private through sales to private equity firms. Many reasons have been suggested for this trend, including the cost in time and money of complying with Sarbanes-Oxley. As is the case with many transactions involving the sale of a public company, a fairness opinion is often provided on behalf of the selling (public) shareholders.
However, many market observers have noted the large returns that private equity investors have earned on these buyouts. Private equity investors typically hold an investment for a five-to-10-year period before selling the company. Public shareholders are increasingly wondering whether they're leaving money on the table and why current management can't do what private equity owners are doing to prepare companies for sale five or 10 years down the line.
It is interesting to note that the current fairness opinion controversy related to private equity buyouts (where it is suggested that the price is often too low) contrasts with the situation with buyouts in general (where there is evidence that the price is often too high).
Conclusion
An understanding of the difference between a fairness opinion and a valuation assignment is essential to properly advising corporate clients and investors. In addition, an understanding of the strengths as well as the limitations of a fairness opinion analysis will enable professional advisors and corporate fiduciaries to provide the best advice to companies involved in a prospective transaction.
About the Author:
Craig Jacobson is a senior manager in the New York City and Westport, CT, offices of Willamette Management Associates. Craig provides valuation consulting, commercial and securities litigation consulting, economic analysis, and financial advisory services. Craig can be reached in New York at 646-658-6231, in Westport at 203-221-3412, and at cajacobson@willamette.com.
