Investors' Needs Drive Fair Value Accounting
As investors increase their demands for financial statements that are more reliable, more relevant, and less an accounting of history (no pun intended), the two primary global bodies charged with establishing standards of financial accounting that govern the preparation of financial reports – Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) – have sought to meet those needs through promulgation of a consistent set of standards.
Chief among these is the identification and recognition of fair value of assets and liabilities in financial statements. FASB's Accounting Standards Codification (ASC) 820 Fair Value Measurement (as updated by Accounting Standards Update (ASU) 2011-04) and IASB's International Financial Reporting Standards (IFRS) 3 Fair Value Measurement, define fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”
Market Participant Acquisition Premium (“MPAP”) Defined
ASC 820 further defines market participants as “buyers and sellers in the principal (or most advantageous) market for the asset or liability” that possess certain characteristics. It should be stressed that fair value is a market-based measurement and does not represent a price that any one particular market participant may be willing to pay for an asset based on its unique risk assessment of, synergistic benefits from, or intended use of the asset. If market participants are able to generate incremental economic benefits through their control prerogatives unavailable to noncontrolling shareholders of an enterprise, they are likely to pay more for that particular asset. In its April 2013 discussion draft “The Measurement and Application of Market Participant Acquisition Premiums,” the Appraisal Practices Board (APB) defines MPAP as the difference between fair value of the subject controlling interest and (for publicly-traded companies) the quoted market price for their shares.
Factors Influencing MPAPs
Valuation analysts need to consider several factors that may impact the level of MPAP for a subject asset in order to appropriately estimate its fair value. Among many others, these factors include:
- Level of merger and acquisition (“M&A”) activity: A large number of transactions within an industry often leads to more competition among acquisitive firms, thus raising MPAPs. Conversely, if noncontrolling owners come to expect higher prices from several bidders, the fair value of the noncontrolling interests may increase over time, thus compressing the MPAP.
- Type of market participant: Broadly speaking, there are either one or two types of buyers in any industry – strategic and/or financial. Strategic acquirers are often competitors of their targets and have the ability to wring out excess costs from a combined operation. Such economic benefits may not be available to financial buyers, thus limiting the MPAP on a relative basis.
- Stage of enterprise development: Target companies that are in an early stage of development offer a more ripe opportunity for cash flow enhancements to potential buyers and, therefore, may have a higher MPAP. For instance, an established pharmaceutical company may be able to leverage its sales network more readily than a young, but up-and-coming, biotechnology company.
- Relative size of market participants: Some industries are characterized by market participant acquirers that are substantially larger than target companies. One example would be the software industry, where barriers to entry are often low but the ability to grow depends on integration with another platform. In such instances, it is not uncommon for a larger market participant to pay a significant MPAP in order to acquire an externally-developed technology.
- ? Capital structure differential: Market participant acquirers have the ability to change a target company's capital structure and will often do so in cases where they are sub-optimal. This ability to lower a target company's cost of capital, thus enhancing economic benefits to the buyer, allows for a greater MPAP.
The list of factors that influence MPAP does not end here and this briefing is not intended to cover all the issues that may have an impact on the level of MPAPs. However, the factors above scratch the surface and provide a framework for a more robust examination of MPAPs and, ultimately, their impact on fair value.