The SFC of Hong Kong published the Statement on the Conduct and Duties of Directors when Considering Corporate Acquisitions or Disposals on 4 July 2019.
As quoted from the SFC’s article, In 2017 and 2018, the SFC issued letters of concern to more than 46 listed issuers about proposed corporate transactions or other actions (The SFC periodically publishes the SFC Regulatory Bulletin: Listed Corporations that highlights cases and provides guidance on the manner in which the SFC uses its powers under the SMLR and the SFO to intervene in serious corporate misconduct at an early stage). More than 55% of these cases involved proposed corporate acquisitions or disposals. Also, the key word “valuation” has appeared 18 times throughout the whole statement, indicating the importance of valuation in a corporate transaction.
As professional valuer actively involved in valuation advisory for corporate transactions, we would like to share our views and insights to financial advisors and listed companies in response to the key highlights from the SFC’s article in relation to valuation. Basically, we recommend adopting a clear decision analysis and process overview in each valuation of corporate transactions.
As quoted from SFC’s Website – Lack of independent professional valuation
Listed issuers are not expressly required by law or under The Stock Exchange of Hong Kong Limited’s Listing Rules to obtain an independent professional valuation in relation to a planned acquisition or disposal. However, it is often the case that obtaining a professional valuation is the obvious and prudent thing for directors to do in order to protect the interests of the company and its shareholders. By not obtaining a professional valuation, directors would have failed to exercise the degree of care, skill and diligence that may be reasonably expected of them.
The SFC has noted that, in a majority of the cases where an independent professional valuation was not obtained, the listed issuers simply announced without further explanation that the consideration was arrived at after arm’s length negotiations, taking into account vaguely described factors such as the target’s business prospects and its alleged leading position in its industry. Often, these bare statements meant that the shareholders of the listed issuer were not being given all the information with respect to its business and affairs that they might reasonably expect.
In our opinion, the benefits of seeking independent valuation outweigh the costs as professional valuation usually provide inputs (depending on actual situation) in the followings:
- Input by valuer in analysis of significant business risks
- Industry overview and prospect of the industry
- Analysis from market participants’ perspective (in addition to company or seller’s perspective)
- In many cases, more than one valuation methods are performed for cross checking. Reconciliation of the results from different methods or analysis to choose the preferred value usually enhances the credibility of conclusion.
- Most of the professional valuers possess professional qualifications in accounting and finance. Their understanding in corporate finance contributes in return analysis, cost of capital analysis, free cash flow analysis and relative valuation analysis by the use of applicable financial models. Not only do valuers build advanced financial models, they also understand accounting issues and are able to provide pre-deal analysis on potential accounting impact incidental to the proposed transaction. For example, earnout terms may create financial liabilities in business combinations (Business Combinations (HKFRS 3) and Financial Instruments (HKFRS 9)) that should be measured at fair value on completion date of an acquisition. It may create fair value impact on profit and loss account on subsequent reporting dates.
As quoted from the SFC’s Article – Lack of independent judgment and accountability
In some cases where an independent professional valuation was obtained, the directors simply relied on the vendors’ forecasts in assessing the consideration for the target businesses. The valuers merely assumed without performing any due diligence or other work that the vendors’ projections would materialise.
The quality of financial projections and forecasts has long been a core issue being criticized in corporate transactions given many incidents of missing forecasts significantly. We will continue to follow our internal guidelines to perform evaluation of financial projections. Industry research and market benchmarking are also useful tools for forecast evaluations.
We would like to remind readers of valuation report to read carefully the Basis of Value and the definition. Although Market Value, Fair Value and Equitable Value are the more commonly used, there are some valuation report is prepared based on Investment Value. Investment Value reflects the circumstances and financial objectives of the entity for which the valuation is being produced. Valuation report prepared under the basis of Investment Value cannot be directly compared with valuation report prepared under the basis of Fair Value. All the bases of value are governed by International Valuation Standard or Financial Reporting Standards and all serve specific purposes. Also, in some cases, valuers are engaged to perform financial model building and calculation report may be issued. However, a calculation report issued by valuers should not be interpreted as a valuation report.
As quoted from the SFC’s Article – Suspicious connected parties
The SFC has noted suspicious transactions that suggest an undisclosed relationship or arrangement among purported independent third parties in some transactions.
From valuation perspective, if we are doing valuation based on Market Value, we value the estimated amount for which an asset or liability should exchange on the valuation date between a willing buyer and a willing seller in an arm’s length transaction.
Depending on the history, corporate structure of the target group, target group’s market position, industry and other relevant factors, dealing or value generated from connected parties can be valued differently. For example, it is fair to consider the value generated from dealings with connected parties with long history at market price.
The level of security of the business with connected parties should also be generally assessed or planned by the acquirer together with how to secure the existing clients and business after the change of control.
Financial due diligence is highly recommended in any corporate transactions, which can help listed companies to evaluate the significance and risk associated with dealings with connected parties. This would help valuer to evaluate whether necessary adjustments should be made in arriving Market Value.
As interpreted from the SFC’s Article – Quality of earnings
In the article, some of the factors are considered as apparent risk factors:
- historical losses
- sudden and unexplained increases in sales
- unjustifiably high margins compared to industry peers
- suspect non-recurring items and apparently questionable or unsustainable sources of revenue
- acquisition premium to enter a new industry with low entry barriers without explaining why it did not simply start the same business itself at a much lower cost.
We agree that such factors are apparent risk factors. In valuation, we stress on valuing the company based on sustainable revenue (and hence earnings and cash flows).
As quoted from SFC’s Website – Fair presentation of comparables
When performing a valuation based on multiples of publicly traded companies, the selection of appropriate comparable companies is important. Valuers and directors must use their judgment to select companies that have suitably similar characteristics to the target company and ensure that the comparables referred to in the valuation constitute a fair and representative sample. The bases for compiling any comparables must be justifiable and clearly stated in the valuation report. In some cases, the SFC noted that the directors “cherry-picked” companies that had higher trading multiples and disregarded others with poorer performance. Moreover, the companies chosen for comparison had significantly longer and more profitable track records than the target companies; however no adjustments were made to account for the differences between the companies chosen for comparison and the targets.
Market approach is easy to understand but difficult to apply well. The complication of a good market approach analysis is usually underestimated. When applying guideline public companies method, the are always many differences between the target companies and the comparables. It is a difficult topic on whether a difference should be adjusted. For example, a large bank and a small bank can both trade at price to book ratio of 1.0x. It is possible a company with higher net profit margin to trade at similar price to earning ratio with another company with lower net profit margin in the same industry. Adjustments should be made on a case by case basis and should be justified. Apart of adjustments, there are other important factors that should be considered. Some of the examples include the followings:
- Which ratio(s) should be used
- Coefficient of variation
- Mean or median may not be always the best conclusion
We have developed our own proprietary system to enhance the depth and accuracy of comparable search. Nevertheless, a systematic process to perform in-depth analysis of the industry, the business model of the target company and the comparables is necessary to fulfill SFC’s expectation on valuation by market approach.
Full Original Statement from the SFC: Link