Next up on the AICPA’s agenda: its conference on fair value measurements and reporting, to be held June 6-8 at the Gaylord Hotel in National Harbor, Md., just outside of Washington, D.C. Key sessions will cover:

• Goodwill impairments, the new standards and the latest, practical application of the qualitative assessments;
• Legal issues related to fair value;
• Fair value and investment companies;
• PCAOB views;
• SEC/FASB update;

Speakers include Ben Couch (FASB), Jay Hanson (PCAOB), David Dufendach (Grant Thornton), P.J. Patel (Valuation Research Corp.), and Mark Zyla (Acuitas). To found out more and to register, click here.

Importantly, “neither term was defined,” observed Ronald Anteau (Kolodny & Anteau) at the AAML/AICPA conference, “and nobody was thinking about the technology we have now.” Shortly after his divorce, Roddenberry remarried and devoted the rest of his life to developing various Star Trek assets; in 1987, his first wife sued his second wife, as well as his production company, claiming half of all the income generated from Roddenberry’s post-divorce Star Trek efforts. (Diehard Trekkies as well as IP analysts and attorneys can read the 1996 California Court of Appeals’ opinion here.)

“The problem in these cases is: who owns the IP if it’s not protected?” commented co-presenter Neil Beaton (Alvarez & Marsal). “Who created the asset? If it’s a patent, then is the patent the value of the company or is the company the value of the patent?” Or think about the “incredible” ways to “slice and dice” the ownership and value of a song, Beaton added. There’s the songwriter, the composer, the producer, and the record company. Tech-related IP is also “rich with land mines,” especially in the volatile, often dangerous context of divorce. “Protect your client and yourself by looking at all variables to identify and value the asset that is divisible by the judge.”

And tune into IP in Divorce: Dividing Patents, Copyrights, and Trademarks, featuring Beaton and Drew Voth (also Alvarez & Marsal), on May 23. The two experts promise to take the emotion out of the analysis, leaving only the logic of IP valuation, as illustrated by recent case law and applied in current best practices and techniques.

Buffet would be proud. To bridge the perceived gap in the curriculum and make the data and tools available, this year the SPU School of Business and Economics and BVR co-sponsored the first annual BVR/SPU Valuation Challenge. After BVR made such tools asPratt’s Stats and the Duff & Phelps Risk Premium Report and Calculator available at no charge, the SPU students (senior undergraduate and graduate finance) formed four teams to appraise a company and compete for the best valuation presentations. In addition,Owen Dahl (Moss Adams) provided a “real world” (redacted) case study for the challenge, and Joel Mass (Synergetic Finance) lent valuable analytical tools.

The competition began in March, with the final presentation and reports due on May 31, when three senior valuation managers from Moss Adams will judge the student teams and decide the winner. So far, the competition has proved to be a “significant success,” Kierulff reports. “Our students are really into this. If you can imagine: they graduate in less than a month, it’s spring, and they are working their tails off in finance. How about that?! I’m just delighted.” We think Warren Buffet would be, too.

Remember, if you don’t have objective market data, added co-presenter Richard Orsinger (McCurley Orsinger Nelson & Downing), IRS Revenue Ruling 59-60 directs appraisers to use the intrinsic value standard. In fact, Orsinger believes that Rev. Ruling 59-60 “applies a road map for intrinsic value under the rubric of fair market value.”

• In valuing any business, “you must be honest with yourself about which businesses you truly understand and those you don’t,” Buffet said. “It is impossible to value a business that you don’t truly understand.”

• Wall Street and the accounting profession have made the situation worse by developing “standardized models” to quantify corporate risks, according to Munger. There is no such thing, the pair of partners agreed; when it comes to assessing risk and opportunity, “what matters most is your facts and your reasoning.”

“We don’t look to public companies for discount rates,” Pellegrino added. “We don’t find that they are representative of the market for early stage companies,” due to the “remarkable” survivorship and other selection biases. “Our view—and this is heresy, I understand—is that the regression-based models are ‘Flat Earth’ thinking.” Consider: Implied discount rates currently developed using regression-based analyses are at historic lows. “My question—and it has been a question I have enjoyed asking over the last three-and-a-half years—is why is there a credit shortage among early stage companies?”

The answer: Investors and institutions are not willing to lend a significant amount of capital to startups unless they get a personal guaranty or “something on the side,” Pellegrino observed. “The reason is because the implied rates of return are actually much greater.”

When asked whether he uses a proprietary or prepackaged modeling software, Pellegrino generously offered the simple, one-page worksheet his firm uses to calculate the discount rate, not only to webinar listeners but to the broader BV community, via our free resources page. Download the Pellegrino & Associates’ Discount Rate Calculator here.

Over 11,000 challenges in 2011. Last year marked the 12th anniversary of the U.S. Supreme Court’s Kumho Tire decision, which expanded Daubert’s reach to financial experts and their opinion evidence. In 2011, alone, there were 11,262 cases citing Daubertor Kumho Tire, according to this year’s Daubert Challenges to Financial Experts by PricewaterhouseCoopers. Highlights of the current report include:

• The number of challenges to financial experts rose every year from 2001 to 2009, but then fell off between 2010 and 2011 by a total of 40%.
• The percentage of successful challenges has varied widely over the past 12 years, with a low of 29% in 2002 and a high of 59% in 2005. In 2011, 54% of all challenges to financial experts were successful in excluding their testimony in whole or in part, or well above the 12-year average of 45%.
• In 2011 70% of all challenges targeted the plaintiff’s expert. Over the same time, however, just about the same number of experts from both sides were excluded, 46% for plaintiffs’ side and 48% for defendants’.
• Challenges to economists, accountants, and appraisers are still the most frequent, last year accounting for 57% of all challenges to financial experts. Notably, accountants and appraisers were excluded much more frequently in 2011 (64% and 70%, respectively) compared with their 12-year average (51% and 46%).
• Breach of contract actions saw the most Daubert challenges during the past 12 years, but once challenged, a higher percentage of fraud and IP experts were excluded (53% and 52%, respectively) than contract experts (44%) and a broad class of “others” (46%).
• For the 12th consecutive year, lack of reliability was the top reason that courts excluded financial experts (7 out of 10 cases), most often due to the lack of valid data or analytical framework for the data. In 2011, alone, lack of reliability supported 76% of the exclusions.

For the second time in four months, Vice Chancellor Leo Strine of the Delaware Court of Chancery charged Goldman Sachs with using “questionable” and “suspicious” valuations to exert a “troubling” influence. The case, involving Kinder Morgan’s bid to acquire El Paso Corporation, raises valuation issues itself that should interest BVWire readers (if only because USPAP compliance appears to have not been a concern for the principals involved!).  In addition, the case seems to open the door to future challenges of questionable i-Banking valuation practices and compliance.

El Paso announces spinoff. El Paso operates a natural gas pipeline business, and also has an exploration and production (E&P) division. In May 2011, El Paso publicly announced that it would spin off the E&P business. In an attempt to preempt other bidders for the spinoff, Kinder Morgan offered El Paso $25.50 per share for the entire company. After consulting with its longtime financial advisors, Goldman Sachs, as well as an independent bank (Morgan Stanley), the El Paso board countered with an offer of $28.00 per share, and sent its CEO to negotiate the deal directly with the Kinder CEO. By late September 2001, the chief executives had agreed on a $27.55 merger price, subject to due diligence by Kinder Morgan.

Just one day after setting the deal terms, however—as V.C. Strine recounts it— “Kinder said, ‘oops, we made a mistake. We relied on a bullish set of analyst projections in order to make our bid. Our bad.” The El Paso CEO backed down, but continued to take the deal on a “downward spiral,” according to Strine, compromised by “debatable negotiation tactics” including:

• Goldman stood on both sides of the transaction, ostensibly advising the El Paso board on the financial soundness of the Kinder bid (for a $20 million fee) while also owning roughly 19% of Kinder Morgan stock (worth nearly $4 billion).
•  Goldman also occupied two seats on the Kinder board, and was part of the control group that collectively held over 78%.of the voting power of Kinder stock.
• More troubling still, the lead Goldman advisor to the El Paso board failed to disclose that he personally owned $340,000 worth of Kinder holdings.
• After Morgan Stanley was brought on to “cleanse” any perceived conflicts, Goldman was able to accomplish the “remarkable feat,” Strine said, of giving the new bankers an incentive to favor the merger by tying their fees to the completion of the deal.
• On the executive side, the El Paso CEO failed to disclose his “secret motive” for closing the deal, which involved making a post-merger management buyout of the E&P division.

In less than a month after Kinder reneged on its original terms, El Paso ended up taking a package that was valued at $26.87 per share as of the signing date (Oct. 16, 2011). The merger price, comprised of $25.91 in cash and stock and a warrant with a strike price of $40 per share, was $13 above Kinder’s then-current stock price and failed to protect against ordinary dividends. The merger agreement also contained a “no shop” provision, preventing El Paso from soliciting other bids, permitting it only to take a “superior offer” for over 50% of its assets, on payment of a $650 million termination fee. This effectively precluded El Paso from spinning off its E&P division to a third party, because it comprised less than 50% of the consolidated assets and the substantial termination fee made the prospect even of selling of its weaker pipeline division prohibitively expensive.

Despite these conditions on the deal, the proposed merger price was at a 37% premium to El Paso’s market value. In fact, after the agreement went public, the price of Kinder’s share rose, thus increasing the merger price to $30.37 per share, or a 47.8% premium over El Paso’s then-trading price. Nevertheless, a group of El Paso stockholders sued to enjoin the merger, asserting numerous breaches of fiduciary duty based on the alleged conflicts of interest.

Questionable decisions based on questionable values. The court agreed that the El Paso board made “numerous decisions” during the negotiations that “could be seen as questionable.” These included the board’s failure to:

• Shop the company its two divisions separately to any other bidder after Kinder’s first overtures, despite knowing that Kinder wanted to deflect other buyers from the attractive E&P division;
• Force Kinder to go public and face market pressure to raise its bid in a hostile takeover;
• Object when Kinder reneged on its original deal, based on the “arguably ludicrous” assertion that it relied on forecasts by one of the “most bullish analysts” covering El Paso’s stock;
• Negotiate deal protections that would permit a post-signing market check for better bids for the separate divisions; and
• Negotiate a deal that at least equaled the value of Kinder’s original offer.

As a result of these failures, the Board was basically down to two options: sell the entire company to Kinder or spin-off its E&P assets. Importantly, although the Board attempted to “wall-off” its conflicted Goldman advisors by bringing in Morgan Stanley, it still permitted Goldman to remain as lead advisor on any spinoff. Thus, Goldman “was in a position to continue to exert influence over the merger,” Strine explained, by revising its valuations of the spinoff downward during the Kinder negotiations.

For instance, using a comparable companies analysis and based on enterprise value to earnings multiples, Goldman valued the E&P assets at $8 billion to $10 billion in May 2011, when El Paso first announced its spinoff plan. By September 2011, when Kinder negotiations were well underway, Goldman said that declining EV/EBITDA multiples caused the E&P assets to lose another $1 billion in value; by October and the closing of the deal terms, their range of value had bottomed out at $6 billion to $8 billion.

By comparison, Kinder Morgan’s advisors valued the same assets as of late September 2011 at $7.86 billion. Moreover, aspects of Goldman’s valuations were “questionable,” Strine noted, because short-term volatility in commodity prices had depressed the market multiples, making them inadequate indicators of long-term value. Further, “solely looking to market multiples to generate a hypothetical trading value fails to take into account the control premium that could be achieved on the sale of the E&P business,” he said.

“Even worse, Goldman tainted the cleansing effect of Morgan Stanley” be refusing to permit Morgan to collect a fee should only the spinoff be consummated.  In other words, if Morgan approved a deal (in which Goldman owned 19% of the acquiring entity), it received a $25 million fee. If it counseled the board to go with the spinoff or another option, Morgan got “zilch, nada, zero,” Strine said.

This fee incentive led to “odd” valuations by Morgan Stanley. For example, evidence suggested that Morgan used an unreasonably low terminal value for a portion of its discounted cash flow analysis of the El Paso pipeline business. That is, rather than use a perpetual growth model to calculate this terminal value, the Morgan analysts used a mid-point exit EV/EBITDA multiple of 10x, which resulted in a long-term growth rate of only 0.7%: “a rate less than half of the estimated rate of inflation (2%),” Strine emphasized. This assumption conflicted directly with testimony from the El Paso CEO, who insisted the pipeline business had strong growth potential. It also conflicted with the management forecasts, used by Morgan Stanley, which included capital expenditures for both maintenance and growth.

The record also revealed that Morgan may have used internally inconsistent values for Kinder’s cost of equity, using a higher rate (11.8%) when benchmarking El Paso’s COE but using a substantially lower rate (7.5%) when valuing Kinder directly.