In Statutory Merger Appraisal Proceeding, Chancery Court, Using Discounted Cash Flow Analysis, Finds Fair Value of Shares to be Below Merger Transaction Price
By Eric E. Freedman and H. Corinne Smith
In In Re Appraisal of SWS Group, Inc., C.A. No. 10554-VCG (Del. Ch. May 20, 2017), the Delaware Court of Chancery, applying discounted cash flow analysis in a statutory appraisal proceeding, determined that the fair value of the stock of SWS Group, Inc. (“SWS”) at the time of its January 2015 merger was $6.38 per share. SWS stockholders had received a mix of cash and stock worth $6.92 per share in the merger transaction. As a result, the valuation determined by the Court in the appraisal proceeding represented a significant discount from the price paid in the merger.
In March 2011, SWS, a small bank holding company that was under considerable financial pressure, entered into a credit agreement with Oak Hill Capital Partners (“Oak Hill”) and Hilltop Holdings, Inc. (“Hilltop”) (the “Credit Agreement”). The Credit Agreement contained a covenant prohibiting SWS from undertaking a “Fundamental Change,” including any sale of SWS, without the consent of Oak Hill and Hilltop. After an extended period of stagnant performance by SWS, market analysts speculated publicly that Hilltop might seek to acquire SWS in a synergies-driven transaction. This speculation caused an increase in the trading price of the stock of SWS. Subsequently, Hilltop did indeed make an offer to acquire SWS. Hilltop’s initial offer of $7.00 per share was rejected as inadequate by a special committee of the SWS board. Meanwhile, SWS entered into active discussions with another entity, Stifel, regarding a proposed acquisition of SWS by Stifel at a price of $8.65 per share. While SWS was in discussions with Stifel regarding the conditions of Stifel’s offer, SWS asked Hilltop to increase its offer to $7.75 per share, and to make its offer firm. Hilltop did so, and shortly thereafter SWS accepted Hilltop’s offer of $7.75, with 75% of the consideration payable in Hilltop stock and 25% of the consideration payable in cash. SWS merged into a wholly-owned subsidiary of Hilltop effective on January 1, 2015. As a result of a decline in the trading price of Hilltop’s stock between the signing of the merger agreement and the closing of the merger, the value of the merger consideration dropped from $7.75 per share to $6.92 per share. After the consummation of the merger, the Petitioners, a series of funds holding appraisal-eligible shares of SWS, initiated an appraisal proceeding under Section 262 of the Delaware General Corporation Law challenging the merger consideration as unfair.
The Court explained that in a statutory appraisal proceeding, the Court has the duty to determine the fair value of the shares without allocating the burden of proof to either party. Although the Court acknowledged that the merger price itself is often the best indication of fair value, the Court rejected that methodology in the case of SWS. The Court did so in part on the ground that neither party relied on the merger transaction price to demonstrate fair value, and in part on the ground that Hilltop exercised partial veto power over competing merger offers by virtue of its approval rights under the Credit Agreement, with the result that the transaction was not sufficiently exposed to the market to make the merger price a reliable indication of fair market value.
The Petitioners’ expert presented a fair value of $9.61 per share, and the Respondents’ expert a fair value of $5.17 per share. Each expert offered a discounted cash flow (“DCF”) analysis to support his valuation. The Petitioners’ expert also presented a comparable companies analysis, and for purposes of his valuation placed 80% weight on his DCF analysis and 20% weight on his comparable companies analysis. The two experts’ discounted cash flow analyses resulted in valuations that were almost mirror images of each other, with the Petitioners’ valuation 50% above and the Respondents’ valuation 50% below the price paid in the merger.
The Court rejected the Petitioners’ comparable companies valuation as unreliable because the companies selected by the Petitioners’ expert were not truly comparable to SWS for valuation purposes.
In undertaking its own valuation, the Court determined that a DCF analysis was appropriate. “The DCF valuation,” stated the Court, “although complex in practice, is rooted around a simple principle: the value of the company at the time of the merger is simply the sum of its future cash flows discounted back to present value.” Noting that the Court has long favored reliable management projections of cash flow for purposes of DCF valuation, the Court, like the parties, used as the starting point for its analysis three-year projections prepared by SWS management in the normal course of business. The Petitioners’ expert made several major adjustments to these projections, and the Court addressed each such adjustment in turn.
First, the Petitioners’ expert extended the management projections for two additional years beyond the original three years. The Court rejected the extension, finding that the assumption of two additional years of “straight-line unprecedented growth” was not supported by the evidence. Next, the Court addressed whether a 2014 warrant exercise by Oak Hill and Hilltop should be considered in valuing SWS, and what, if any, amount of excess regulatory capital held by SWS should be assumed to be distributed to shareholders for purposes of the valuation model. The Court acknowledged that it must exclude speculative elements of value that arise from the “accomplishment or expectation” of a merger. However, the Court found that the 2014 warrant exercise was sufficiently unrelated to the merger to be considered fairly an element of SWS’s ongoing “operative reality.” On the question of whether the excess regulatory capital held by SWS should be considered to be distributed to shareholders for purposes of calculating cash flow in the DCF valuation model, the Court deferred to management projections, which assumed that the warrants would be exercised in 2016 rather than 2014 and therefore did not contemplate any such earlier distribution of excess regulatory capital in projecting SWS’s cash flows.
The Court concluded that the DCF analysis resulted in a fair value of $6.38 per share, a value considerably below the merger price. This lower value was “not surprising,” in the Court’s view, given that the merger was “a synergies-driven transaction whereby the acquirer shared value arising form the merger with SWS.”