What are control premiums?

The control premium controversy

The control premium story changed over thirty years ago, but the application of control premiums still appears to be a controversial matter.

The old story

The control premium story use to go something like this…

The market price of a public company’s shares reflects the price paid in the exchange of small parcels of shares. These small parcels of shares are considered to represent minority interests. Consequently,if valuing a controlling interest the market share price needs to be adjusted to arrive at a control value. A control premium needs to be added.

This all seems very reasonable and logical. Indeed, there are plenty of good reasons why a buyer may be prepared to pay a premium for control, for example, controlling the direction of the business, controlling the markets the business operates in and the customers it serves, changing reinvestment and dividend policy, altering the capital structure,and changing the management and directors.

The International Valuation Standards appears to support this view. Per IVS 105, shares of public companies generally do not have the ability to make decisions related to the operations of the company and as such, when applying the guideline public comparable method to reflect a controlling interest a control premium may be appropriate.[1]

Evidence for control premiums

There is seemingly some good evidence to support control premiums, for example:

• The 2021 RSM Control Premium Study analysed 605 Australian control transactions in the fifteen-year period to December 2020. The Study found that the implied average observed control premium for companies on the ASX to be 34.7%, based on a 20-day pre-bid price.^[2]
• A Mckinsey & Company study, analysed 1,640 deals over seven years and found that on average companies were making acquisitions at a premium of 40% or more of the target’s market value.[3]

The new(ish) story!

In June 1990 Eric Nath published an article Control Premiums and Minority Discounts in Private Companies in the American Business Valuation Review. In the article Eric Nath postulated that takeovers represent only a small portion of the public marketplace, but if all public companies trade at a discount to their controlling value, why aren’t all public companies taken over?![4]

Mr Nath elaborated nearly twenty-five years later with this thought. Next time you are buying or selling shares, stop and ask yourself if you have adequately discounted the price because you personally were not able to appoint management, change the board of directors, set operational or strategic policy, change the course of the business etc?! [5]

Reasons for the observed premiums

Eric Nath argues that price premiums are likely paid for three key reasons:[6]

1. Target undervalued. This maybe because the target is either mismanaged and underutilised or,alternatively thetarget is optimally run but this is not communicated effectively to or understood by the market.
2. Strategic value. The target may be run optimally but the acquiror can access synergistic benefits through the acquisition.
3. The acquiror pays too much!

According to an academic review of research papers on mergers and acquisitions, between 50% and 83% of transactions fail. Failure being defined as either acquisition goals are not met and or operating results deteriorate.[7] Further, approximately 70%-80% of merger and acquisition transactions do not create significant value above the annual cost of capital.[8] Some acquirors simply pay too much!

Eric Nath’s first two reasons for the acquisition premiums paid principally relate to the two fundamental valuation inputs: cash flow and rate of return. This agrees with the International Valuation Standards, where the standards acknowledge that the willingness to pay a control premium will relate to the ability to enhance economic benefits. These benefits being calculated through cash flow enhancement or risk reduction.[9]

According to Shannon Pratt, investors generally will not accept a lower expected rate of return for the purchase of a controlling interest than for the purchase of a minority interest. Control buyers pay premiums because they expect to do something to increase the cash flows, not because they are willing to accept a lower expected rate of return.[10]

Summary

If public companies tend to trade at or near their takeover value then the application of a premium to valuation multiples of public companies would be inconistent. Guideline public companies provide insight into controlling values. The application of premiums would only be applicable if it can be shown that the guideline public companies are undervalued and the market inefficient.[11]

[1] International Valuation Standards 105 paragraph 30.17 (b)(1), page 40, effective 31 January 2022.

[2] 2021 RSM Control Premium Study, page 4. Implied control premiums are calculated as the (offer price – share) price/share price, where the closing share price of the target is 20 days pre the takeover announcement, see page 12 of the Study.

[3] Agrawal, A, Varma, R and West A, Making M&A deal synergies count(October 2017), page 1

[4] Nath, E, Control Premiums and Minority Interest Discounts in Private Companies, Business Valuation Review, June 1990, pages 39 and 49.

[5] Nath, E, Views on Control Premiums, BV Success American Society of Appraisers (2013), page 1.

[6] Nath, E, Control Premiums and Minority Interest Discounts in Private Companies, Business Valuation Review, (June 1990), page 40.

[7]Koi-Akrofi, G Y, Mergers and Acquisitions Failure Rates and Perspectives on why they fail, Internal journal of innovation and applied studies (2016) pages 152 and 153.

[8] Bruner, R F, Does M&A pay? A survey of evidence for the decision-maker, Journal of Applied Finance (2002), per as referred to in Mergers and Acquisitions Failure Rates and Perspectives on why they fail, page 153.

[9] International Valuation Standards 105 paragraph 30.17 (b), page 40, effective 31 January 2022.

[10] Pratt, S, Cost of capital – estimation and applications (2002), Wiley & Sons, page 153.

[11] Nath, E, Control Premiums and Minority Interest Discounts in Private Companies, Business Valuation Review, (June 1990), page 45