BULLS & BEARS: Conflict of interest arises when valuing companies

When two companies engage in an acquisition, within the proxy documents delivered to shareholders a “fairness opinion” is routinely provided. The fairness opinion is an analysis of the transaction typically conducted by an investment bank. Corporate boards hire these “third-party” advisers to satisfy their fiduciary duty to shareholders and to protect against legal challenges over a decision to do a deal.

These opinions may be delivered by investment banking firms who have no other role in the deal. But they also are prepared by investment banking firms that originally proposed the deal to management and who stand to collect a “success fee” that is a percentage of the deal’s price at completion.

Recently, officials at the National Association of Securities Dealers Inc. (NASD) have expressed concern over fairness opinions. When the incentive for investment bankers is to see the deal get done, the tendency may be to accommodate management and declare that the terms of a proposed deal are fair.

When AES Corp. acquired Indianapolis based IPALCO Enterprises Inc. in a $2.2 billion deal in 2001, UBS Warburg provided the fairness opinion for IPALCO shareholders and received a $2.3 million fee. In addition, upon completion of the deal, Warburg received an additional $6.4 million.

In a typical fairness opinion, the investment bankers will compare the acquisition price with the financial statistics of comparable publicly held companies. In addition, the adviser usually will review the prices of recent transactions that have taken place within the same industry.

In the AES-IPALCO fairness opinion, Warburg reviewed three companies comparable to AES in the power-generation industry. Tables in the proxy showed these companies had a mean price-toearnings ratio of about 37 and traded at a multiple of 32 times cash flow, generous valuations by any standard. Today, of the three companies used as comparables to AES in 2001, one eventually went bankrupt and the other two are on life support.

Thus, there is debate on how useful the analysis contained in fairness opinions is to shareholders. Recently, one of our security holdings proposed a reverse split in an effort to reduce the number of shareholders outstanding. Owners of fewer than 1,500 shares were to be cashed out at a certain price. An opinion was provided to us that suggested the cash-out price was fair. However, it was glaringly apparent that this price was far too low a valuation for the business and instead we bought more shares.

On the humorous side, Warren Buffett told a story in his 1999 annual letter about one of his acquisitions. Apparently, a fairness opinion had previously been conducted on the company his firm was about to purchase. The banking firm’s contract provided the firm a $2.5 million fee upon sale, even if it had nothing to do with finding the buyer. He wrote, “I guess the lead banker felt he should do something for his payment, so he graciously offered us a copy of the book his firm had prepared. With his customary tact, Charlie (Munger) responded: ‘I’ll pay $2.5 million not to read it.'”

In June, the NASD filed with the U.S. Securities and Exchange Commission proposed rules that would require certain disclosures to be contained in fairness opinions, as well as mandate specific procedures to be followed by member firms in connection with issuing their opinions.