The fallacy of applying a ‘standard’ control premium

This is an update of an article by Stephen that appeared as a Perspective on the website of Chartered Accountants Australia + New Zealand in 2021[1]. 

We often observe takeover premium data or studies (mis)used in valuations, the rote application of ‘standard’ control premiums to comparable company multiples and in determining minority interest discounts.  However, there is no evidence of control premiums paid in Australian transactions, nor is there justification for a ‘standard’ control premium.

A typical ‘levels of value’ chart is set out below[2]. 

This post focuses on the difference between a takeover premium, control value and marketable minority interest value.

To determine a control multiple for a multiple of earnings valuation or cross check, a valuer will commonly gather evidence of multiples implied by acquisitions of comparable companies (which are generally, but not always, for control) and multiples implied by share trading in comparable listed companies.  In order to bring the multiples of the listed companies to the same ‘level of value’ as the comparable transactions, control premiums are frequently incorporated in the calculation of earnings multiples for comparable companies, by adding a ‘standard’ control premium to the market capitalisation of the listed comparable company[3].  The ‘standard’ control premium is commonly based on ‘studies’ of observed premiums in takeovers.  The (rough and flawed) logic of this approach is that, if a valuer is determining the control value of a company by reference to comparable listed companies, it is necessary to add a premium to the observed market capitalisation of the comparable companies, as the ASX listed price represents the price for a liquid minority interest.  The circular presumption is that a control value will always be more than a minority interest value

Similarly, control premium studies are also used as a basis for estimating the level of minority interest discount applied in the calculation of a minority interest value.  The minority interest discount is the inverse of the control premium[4].

The apparent simplicity of the ‘levels of value’ is appealing, as valuers can readily step up and down between the levels of value with ease, by applying control premiums and minority interest discounts.  However, the assumption that takeover premiums exist for all companies, in all industries, at all times, is not established by studies of takeover premiums, as such studies only measure the premiums for companies that were taken over.  Nor is it established that there is a standard premium, of roughly the same amount, that can be applied to any situation.  For these reasons, both practices described above are flawed.

Control premium Vs takeover premium

The terms control premium and takeover premium are often used interchangeably, whereas they are different concepts.  A study of observed takeover premium data measures the takeover premiums achieved on completed takeover transactions – there are some nuances in relation to how these studies are compiled, such as the time periods covered by the studies and the periods over which the premiums are measured. The premiums observed reflect the transfer of control as well as the value of any synergy benefits that the bidder may be able to realise.  They could also reflect the fact that the target company’s stock is illiquid, or the operations of the business could be poorly understood by the market (and hence mis-valued). 

A control premium, on the other hand, represents “an amount (expressed in either dollars or percentage form) by which the pro rata value of a controlling interest exceeds the pro rata value of a non-controlling interest in a business enterprise that reflects the power of control”[5].  The power of control would relate to the commonly (over) stated levers of control, such as the ability to appoint directors to the board, change the dividend policy and so on.  A control premium is a possible component of a takeover premium.

Takeover premiums do not just measure control and there is no ready measure of control premiums in isolation. In addition, takeover premium studies, which do not only measure control, measure the premiums that resulted from successful takeovers, but do not provide any information on the premiums that might apply in respect of all the listed companies that were not taken over

Each year, about 30 companies (give or take) are taken over on the ASX, leaving 2,000 or circa 98.5% of companies listed on the ASX.  If a takeover premium applied to every company, given the weight of money seeking to find value on the ASX, every company would theoretically be taken over.  Why would any company IPO if there was a takeover premium for every company … as a trade sale would always yield a better outcome for shareholders.  So, what is going on here?

There is an interesting interplay between two elements underpinning the ‘levels of value’ chart, liquidity and control, both of which are, in reality, a continuum.  A marketable minority interest is highly liquid (although liquidity varies tremendously across ASX listed stocks) and affords a total lack of power.  A 100% controlling interest has some liquidity and absolute power/control.  Where an acquirer can create or obtain significant benefits from control, the net benefit, after taking account of the reduced liquidity of a controlling interest compared to a marketable minority interest and transaction costs, may justify a takeover of a company at a value that is greater than the marketable minority interest value.  However, where the benefits of control are more limited, the value of a controlling interest in a company may be insufficient to support a takeover, after taking account of the more limited synergies and reduced liquidity associated with control. 

Let’s look at the value equation from the perspective of the willing buyer and willing seller.

Willing buyer

A bidder will determine its bid price based on the cashflows that it expects to derive from the acquisition.  That is, the bidder may expect to derive superior cashflows compared to those for the stand-alone listed company.  There are two key factors that could contribute to these superior cashflows:

• Poor management – the bidder may seek to install good management in place of poor management, where the target company is being mismanaged.  This clearly relates to control, as control enables the management to be swapped out.  And perhaps a shareholder in a company that is wildly mismanaged may achieve a higher control premium in a takeover than shareholders of a moderately mismanaged company
• Synergies – the bidder may be able to extract synergies from the business, which it is prepared to pay to the vendor shareholders (which may also be related to the level of interest in the target).  Obviously the greater the synergies available to a pool of hypothetical purchasers, the greater the potential takeover premium.

The extent to which superior cashflows exceed stand-alone cashflows will depend on the extent of poor management and available synergies, which will obviously vary by company.

Clearly, it would not be appropriate to blindly apply a takeover premium to valuation metrics, where there would not be significant synergies available to a hypothetical bidder and/or the company is not mismanaged.

Willing seller

It is often noted that for takeovers to be successful a takeover premium would need to be at least 20% and typically more like 30%.  This likely reflects the need for the takeover bid to cause a sufficient number of shareholders to accept the offer to make the takeover successful.  Shareholders will have different opinions on the value of the stock – the traded market price of a share represents the price paid by the most optimistic buyer and the most pessimistic seller.  The higher the takeover bid price, the more likely a sufficient number of shareholders will be willing to accept the offer to make a takeover bid successful.  Where superior cashflows available from a takeover justify, from the perspective of the bidder, a takeover bid only, say, 5 to 10% above the traded market price of a company, the bid may not be made because it will fail to attract sufficient seller interest.

Takeover premium studies

As mentioned above, a study of observed takeover premium data measures the takeover premiums achieved on completed takeover transactions[6].  As you may appreciate from the discussion above, the takeover premium on a particular deal represents the economics and opportunities associated with that deal, it is an outcome.  Except in relatively limited circumstances, it would be a coincidence if the economics of one deal were equivalent to another.  And, obviously, takeover premium studies say nothing about the premiums that might exist for all the companies not subject to a takeover.

Here is the distribution of returns from takeover premiums arising from actual transactions in Australia from 2001 to 2018:

There is a wide range of premiums implied by the transaction outcomes covered by this survey.  The wide distribution of outcomes, in itself, should give pause for thought on the appropriateness of adopting a premium as an input into a valuation.  What value for a premium should you select and why?[7]

It would be interesting to study premiums on deals where there are no synergies (e.g. a financial buyer) or poor management, if any, to isolate a premium that might relate to control in isolation. It is difficult to come up with examples of deals in this category.

Market practice

The recent 2022 Business Valuation Practice Survey conducted by CAANZ (the Survey) had three questions relating to control premiums, which highlights how embedded these practices are:

1. What approach do you apply to control premiums?  3% of respondents apply a default control premium, 81% apply a control premium based on the circumstances and 15% do not apply a control premium.
2. For the 3% (or 2 respondents) that adopt a control premium, what range do you currently adopt as the default control premium in the Australian/NZ market?  It would appear from the survey output that the average control premium adopted is 25%.
3. For the 81% of respondents that apply a control premium based on the circumstances, what range do your adopted control premiums typically fall (assuming valuation of 100% interest)?  46% of this cohort generally adopt control premiums of 20-30%, 34% responded 15-35% and 21% responded 10-40%. 

A few observations emerge from these responses:

• The default control premium adopted by the respondents to question 2 is equal to the midpoint of each range in question 3, with the point of difference between respondents being the range around 25%.  This is likely due to survey design.
• The survey did not ask respondents to provide any further information on what would cause them to select a control premium at one end of their range or the other.
• It would be interesting to know what “anchors” the respondents views of an appropriate control premium, if not studies of takeover premiums, given we are unaware of any Australian studies or research that measure the impact of control in isolation.  The survey did not seek responses on this.

In practice, we observe valuers applying control premiums in reports between 20-40%, mostly 30%, without differentiating the circumstances of the situation or companies being studied.  We looked at ten recent Australian Independent Expert’s Reports prepared by ten different experts.  Six applied a control premium somewhere in their analysis; one referred to the fact that, if they did incorporate a control premium, the impact would be significant and three made no adjustment.  Of the six that applied a control premium:

• In one of the cases the expert appeared to consider the circumstances of the company being valued in applying a control premium, but not so for the other five that adopted control premiums
• Three of the experts adjusted the multiples of comparable companies by 30/35%, although the comparable companies were not being taken over and there was no analysis of whether there would be synergies available to a pool of purchasers, or whether the companies were mismanaged and there was a reasonable probability that a transaction was imminent
• One of the reports referred to the RSM study footnoted above although, again, there was no analysis of whether there would be synergies available to a pool of purchasers or whether the companies were mismanaged
• Lastly, one of the experts referred to takeover premium studies when determining a discount for minority interest (as a reciprocal).  In this case the expert used an asset-based methodology to value a resources exploration company to determine the ‘control value’ of a share.  Presumably the cashflows available to a minority interest holder in the company would be no different to those of a controlling shareholder on a pro rata basis and the NAV ‘control value’ was not pregnant with the synergies available to a hypothetical acquirer of the business, so the takeover premium studies are not relevant in determining a minority interest discount.

Implications

It is worth considering the extent to which your valuation, and the information on which your valuation is based, takes account of mismanagement or synergies.  If there is no suggestion or indication that a company is being mismanaged and there are limited synergies, there may not be a significant difference between superior cashflows potentially available to an acquirer and standalone cashflows. 

There may be no need for a discount for minority interest, if you are valuing a minority interest in a widely held mismanaged private company, where the probability of a change of management is low.  This would be the case if your expected cashflows are based on the incumbent management’s plans.

It would be double counting to adjust listed comparable company multiples to reflect control, if you are valuing a controlling interest in a company and your assessed maintainable profits reflect a well-managed company and there are limited synergies available to a hypothetical acquirer, or the synergies that are available are reflected in your assessed maintainable profits.

If your assessed maintainable profits reflect a mismanaged business, perhaps it is better to model the benefits of good management, if you are valuing a controlling interest in the company, rather than select an arbitrary ‘standard’ control premium. 

Where you are valuing a controlling interest in a company, you may, for example, observe that recent transactions in genuinely closely comparable companies are occurring at multiples that are greater than those implied by share trading in genuinely comparable listed companies.  This may reflect the fact that there are hypothetical acquirers of comparable companies at a takeover premium, which presumably are able to derive some kind of synergy across a sector.  An example of this could be Aconex, a SaaS provider of a global platform connecting teams on construction and engineering projects, which was acquired by Oracle in 2018.  In the period prior to this deal there were a number of transactions in the relevant sub-sector of the SaaS industry, notably by Oracle, at significant premiums to the liquid minority prices.  In this situation, the comparable transaction multiples could be a good source of valuation evidence to inform your valuation, without the need for a control premium applied to comparable company trading multiples.

Final comment

This post focuses on the difference between a synergistic value, control value and marketable minority interest value.

The premiums observed in takeover studies are derived from those transactions, where bidders believed they could achieve superior cashflows at a level that would support a bid that would induce enough shareholders to accept the offer.  To succeed, it is generally necessary for there to be both superior cashflows anticipated by the bidder and a sufficient premium to motivate the vendor shareholders.

We understand the appeal of the simplicity of the ‘levels of value’ chart, enabling valuers to step up and down between the levels of value with ease, by applying control premiums and minority interest discounts.  However, the assumption that takeover premiums exist for all companies, in all industries, at all times, is not logical and is not proved by studies of takeover premiums.  Therefore ‘standard’ control premiums should be adopted with extreme caution.

Where the subject company or comparable listed companies are not in the process of being taken over, there are limited synergies available to a hypothetical acquirer or there is no evidence the company is mismanaged, it should not automatically be assumed that a takeover premium could be obtained by their shareholders.

Our preference is to study the cashflows and projections to understand what ‘level of control’ is built into the cashflows and, wherever possible, to take account of level of value issues in the cashflows.  We gave some examples, above, to illustrate how to think about this issue. The areas to focus on, that may give rise to possible takeover premiums, are synergies available to bidders and/or mismanagement

A valuer should also seek to understand the extent to which the share prices of the company being valued or the comparable companies are affected by poor communication with the market or poor liquidity (given, as noted above, liquidity is a continuum). 

This is a complex, interesting, topic and I challenge you to reconsider your practices if you are in the habit of automatically incorporating ‘standard’ control premiums in comparable company multiples, to determine the control value of a company, and using takeover bid premium data to determine minority interest discounts, when valuing marketable minority interests.

Having read the above, are there any areas where you consider it is useful to have a standard control premium?  And do you have any ideas on how ’control’, in isolation, could be measured? You can comment below.

Further reading

The issues discussed in this post have been debated for years, mostly in the US, and this post has not delved into all nuances of the debate.  Here are some suggestions for further reading:

“Business Valuation: An Integrated Theory” (third edition), Z Christopher Mercer and Travis W. Harms 2021

“Valuations in Financial Reporting Valuation Advisory 3: The Measurement and Application of Market Participant Acquisition Premiums”, The Appraisal Foundation, 6 September 2017

“Control Premiums and Minority Interest Discounts in Private Companies” by Eric Nath, Business Valuation Review, June 1990

“A Tale of Two Markets” by Eric Nath, Business Valuation Review, September 1994

“The Value of Control: Implications for Control Premia, Minority Discounts and Voting Share Differentials” by Professor Aswath Damodaran, New York University-Stern School of Business, 30 June 2005

Business Valuation Resources webinar, February 2014 (reproduced in “Update on Control Premiums – What the Experts Say”, Business Valuation Resources, May 2015

“Business Valuation – Discounts and Premiums”, Second Edition, Shannon P. Pratt, 2009

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[1] Control values the fallacy of applying a standard takeover premium | CA ANZ (charteredaccountantsanz.com)

[2] Pratt, Shannon P. (2009) Business Valuation – Discounts and Premiums, Second Edition, Shannon P. Pratt, 2009, page 5

[3] For instance, EBIT multiple = Market capitalisation of comparable company x (1+30%) / EBIT, with 30% being a ‘standard’ control premium

[4] Minority interest discount = 1 / (1 + control premium)

[5] Pratt, Shannon P. (2009) Business Valuation – Discounts and Premiums, Second Edition, Shannon P. Pratt, 2009, page 16

[6] For example, RSM prepared and published this control premium study in 2021.  The study slices and dices control premiums on a number of dimensions such as size and industry but does not show the distribution of returns or other statistical measures such as standard deviation of the premium outcomes.

[7] The distribution is a T-distribution with fatter tails than a normal distribution