Cont Considerations - Fair Value Conf SF FINAL...Illiquid Credit Instruments: Amanda assists clients...

Contingent ConsiderationsStriving for ConsensusNovember 2013

Amanda Miller has over fifteen years of experience in helping clients to understand and manage risk, assess probabilities of uncertain events, anddevelop quantitative models to measure value in an uncertain world. She specializes in assisting clients with the valuation of illiquid investments,equity & fixed income derivatives, contingent assets and liabilities and other complex securities. Specific areas of focus include:

► Privately-Held Company Securities. Amanda assists clients in the use of option pricing models and probabilistic analysis to value options,warrants, preferred and common stock in privately-held companies with complex capital structures, considering both the economic rightsassociated with these instruments as well as discounts related to the marketability of these securities in the available exit markets. Clientsuse these analyses for financial reporting purposes, tax planning and investment decision-making. In addition, she assists clients with thevaluation of management incentive plans, including those with performance-based and market conditions, and has led several projectsconsidering the valuation ramifications of various incentive plan structures for global clients. Amanda was a member of the AICPA Task

Amanda A. Miller, PhDExecutive Director – Complex Securities Group, Valuation and Business ModelingRedwood Shores, California

Tel: +1 650-802-4522Fax: +1 866-215-8262Email: [email protected]

considering the valuation ramifications of various incentive plan structures for global clients. Amanda was a member of the AICPA TaskForce that recently released the updated guide, Valuation of Privately-Held Company Securities Issued as Compensation.

► Private Equity & Venture Capital Investments: Amanda assists private equity, venture capital and other investment companies withvaluation issues related to financial reporting related to their portfolio investments under ASC 820. Amanda is a member of the AICPA TaskForce that is developing a new guide, Determining Fair Value of Portfolio Company Investments of Venture Capital and Private Equity Firmsand other Investment Companies.

► Illiquid Credit Instruments: Amanda assists clients in understanding the value of their illiquid fixed income investments, including auctionrate securities and structured products.

► Contingent Considerations and Other Probabilistic Instruments. Amanda designs probability-weighted models to capture the full rangeof possible outcomes and estimate values under uncertainty. These engagements help clients gain confidence in the projections used infinancial planning and financial reporting for transactions, technology investments, “but for analyses” for litigation, and strategic decisionmaking. In addition, these analyses are used in the valuation of contingent considerations under ASC 350, for analyzing warranties andother guarantees under ASC 460-10, and to help companies determine whether they need to consolidate certain variable interest entitiesunder ASC 810-10 and for Value at Risk forecasting and model validation for the banking industry.

Amanda earned her Ph.D. at Stanford University in Electrical Engineering in 1994, where her thesis developed a new statistical approach forPositron Emission Tomography (“PET”) imaging. She also holds dual M.S. degrees from Stanford in Statistics and Electrical Engineering, anddual B.S. degrees from the California Institute of Technology in Mathematics and Engineering & Applied Science. She completed the BerkeleyFinance Series programs in Derivatives and Bonds, ABS & Risk Management in 2007.

Biljana (Biki) MarijanovicSenior ManagerComplex Securities, Valuation & Business ModelingErnst & Young, [email protected]+1 415-894-8279

Biljana Marijanovic has over six years of experience in assisting clients with the valuation of equity securities and derivatives, debtsecurities, hybrid securities, contingent assets and liabilities, and other complex contracts. Specific areas of focus are:

Valuation of equity derivatives

► Warrants, employee stock options, convertible notes and convertible preferred

► Embedded derivatives present in convertible bonds, convertible preferred or other hybrid instruments. Examples includeconversion and early redemption features, make whole provisions, change-in-control and other company specificcontingencies of convertible debt

contingencies of convertible debt

► Preferred and common stock in privately-held companies with complex capital structures

Valuation of debt instruments

► Corporate debt, intercompany debt, mezzanine and early stage debt, as well as debt modifications taking into account currenttrends in a company’s cost of borrowing and performing synthetic credit rating analyses

► illiquid credit Instruments, including convertible notes and related derivatives

Contingent considerations and other probabilistic instruments

► Design of probability-weighted models to capture the full range of possible outcomes and estimate values under uncertainty.In particular, valuation of contingent considerations under ASC 805 and mark-to-market accounting.

Biljana earned her M.S. at University College, London, UK in Mathematical Modeling. She holds dual B.S. degrees in AppliedMathematics and Electrical Engineering from Southern Methodist University, Dallas, TX.

Agenda

► Introduction

► Why is it so complicated?

► Appraisal Foundation’s Working Group

► Overconfidence

► Current Valuation Approaches – the Evolution

► Closing Observations

Introduction

Buyer’s vs. Seller’s Perception

Bridging the Gap

Why is it so complicated?

Contingent Consideration Risk Taxonomy

Capped CallDebt Digital Option Equity Call Option

Increasing level of riskIncreasing level of risk

1

► The greater the risk, the greater the required rate of return

► Debt like payments have an associated price of risk equivalent to the cost ofdebt

► Equity type payout structures have an associated price of risk equivalent tothe cost of equity

► Call options have an associated price of risk that depends on the risk of theunderlying metric, "moneyness", volatility, and time to expiration; this risk canfar exceed the cost of equity

Increasing level of riskIncreasing level of risk

Non Linear Payoffs versus Linear Payoffs

Forecast: $10mPay: 10x EBITDA

Price: $100m

Forecast: $10mPay: 10x EBITDAiff EBITDA ≥ $10m

Price: ????

Non Linear Payoffs versus Linear PayoffsWhat’s the difference?

Pa

yoff

20

0

Pa

yoff

20

0

EBITDA

Linear

105

10

0

20

50

EBITDA

Non-Linear

105

10

0

20

50

10 x ($5m x 50% + $15m x 50%)

= 10 x $10m

= $100m

payoff associated with the

=50% x (10 x $5m) + 50% x (10 x $15m) =

$25m + $75m =

$100m

probability weighted average payoff

Non Linear Payoffs versus Linear PayoffsDoing the math – Linear

payoff associated with theprobability weighted avg EBITDA

probability weighted average payoffassociated with each EBITDA

10 x ($5m x 50% + $15m x 50%)

= 10 x $10m

= $100m

payoff associated with the

=50% x (0 x $5m) + 50% x (10 x $15m) =

$0m+ $75m =

$75m

probability weighted average payoff

Non Linear Payoffs versus Linear PayoffsDoing the math – Non-Linear

payoff associated with theprobability weighted avg EBITDA

probability weighted average payoffassociated with each EBITDA

Contingent Consideration Risk Taxonomy

Risk of theunderlyingoutcome

Risk of the

► Business level metrics (before capital structureconsiderations) carry a firm level of risk.

► Equity level metrics (after capital structureconsiderations) carry an equity level of risk

► Varies with the participation of the contingentconsideration in the underlying once a hurdle is met

1

Risk of thefunctional

form

Risk of theacquiringcompany

► Generally represented by the subordinated credit riskof the acquiring company

► In specific cases, the risk of the acquiring companymay be highly correlated with the success of thecontingent consideration

consideration in the underlying once a hurdle is met

► Payouts typically resemble a combination of otherfinancial instruments such as debt, equity, digital calloptions, call spreads, and standard call options

Appraisal Foundation

Appraisal Foundation’s Working Group –Contingent Considerations

► Goals► Build consensus among the firms regarding appropriate approaches

► Reduce diversity in practice

► Topics to be covered► Introduction, Purpose and Scope

► Valuation Methodologies

► Complex vs. simple models used as approximations

► Approaches for addressing uncertainty

► Key questions

► Estimating cash flows (calibration to the forecast, volatility)

► Risk of the underlying metric – revenues vs. earnings

► Counterparty risk

► Technical milestones

Overconfidence Assessment

Overconfidence!

► Overconfidence has been called the most “pervasiveand potentially catastrophic” of all the cognitive biasesto which human beings fall victim. It has been blamedfor lawsuits, strikes, wars, and stock market bubblesand crashes.

* Moore, D. A., & Healy, P. J. (2008), “The trouble with overconfidence”,Psychological Review, 115(2), 502-517.

Evolution of Valuation Methodology

Working with Uncertainty

CB

outcome 2A D

outcome 1outcomes

We don’t use stochastic models because we like them.We use them because we need to.

Current Valuation Approaches –the Evolution

► We have come a long way…

► 2 Main approaches have emerged► PWERM (Probability Weighted Expected Return Method)

► Options pricing method

PWERM – Pros and ConsDiscounts Probability Weighted Pay-off

• Management control scenarios and

probabilities

• Lots of subjective assumptions

• Management tend to be over-

optimistic

• Difficult to estimate the discount

Cons

• Management control scenarios

and probabilities

• Understandable

• Flexible

Pros

rate

• Difficult to apply to path-dependent

pay-offs

• More difficult to ensure consistency

between assumptions

Options Pricing Approach – Pros and Cons

• Widely used to value securities

with non-linear payoffs

• Less assumptions than PWERM

• More objective than PWERM

• No need to contemplate the impact

of the non-linear pay-off on the

Pros

• Perceived to be complex

• Not widely understood

• More rigid than a PWERM

Cons

of the non-linear pay-off on the

discount rate

• Can handle path-dependent pay-

offs

• Coherent framework makes it

easier to ensure consistency of

assumptions

Main Issues

► Consistency in assumptions for the underlying metric► PWERM: Probability distribution of underlying (forecast and risk)

vs. risk-adjusted discount rate of underlying/IRR

► Options pricing: Volatility vs. discount rate of underlying

► Discount rates for PWERM► Valuation specialist’s do not understand risk-neutral valuation

► Valuation specialist’s do not understand risk-neutral valuation

► Valuation industry is not technical enough to convert probabilitiesto risk-neutral

► Wang transform, stochastic deflators, … there are others (nice toknow, but not covered today)

Closing Observations

Thank You

Questions?

Cont Considerations - Fair Value Conf SF FINAL...Illiquid Credit Instruments: Amanda assists clients...

Documents

Transcript of Cont Considerations - Fair Value Conf SF FINAL...Illiquid Credit Instruments: Amanda assists clients...