An informal discussion on the valuation of enterprises by investment Institutions (19): Control Premium

Abstract: The value of the enterprise is largely determined by the management level of the enterprise. To run a business, leaders need to constantly make various decisions, such as what to do, where to invest, what to vote for, how to finance, and how to create value for shareholders

The value of an enterprise is largely determined by the level of management of the enterprise. To run a business, leaders need to constantly make decisions, such as what to do, where to invest, what to vote, how to finance, and how to create value for shareholders. When valuing an enterprise, the investment agency will ask, "who is running this business?" How did he manage it? "In other words, even if it's a good company, it's worth a lot of value if it's run by an incompetent CEO." If the business is run by a CEO with an entrepreneurial spirit and a very high level of management, it will be valued much higher. The difference between the two scenarios we are talking about is the control premium.

Professor Damodaran, the famous investment guru, summed up 5 channels for the enterprise to achieve higher value:

more efficient operation and management, so that existing assets to generate more cash flow. Increase growth rates by accelerating investment or investing in better projects when the market is good. Increase the current competitive advantage to extend the time of the high growth period. Change the proportion or means of financing to reduce the cost of capital. Manage non-operating assets so that they do not depreciate.

It's easier said than done. Not all businesses are like eight claw fish, and they can be exhaustive. We have emphasized in the Valuation Series (13) that it is worthless if the acquisition does not produce synergies. But if a poorly managed enterprise were to be replaced by a new owner, the acquired enterprise would operate in a better way, and the acquisition would have value. Here we introduce a "control premium" concept. That is, the acquirer is usually even willing to pay more than the company's current valuation to buy the company's control.

But the control premium is not necessarily due to synergies (such as the cost savings or increased revenue generated by mergers and acquisitions, resulting in future cash flow growth), as synergies arise because of the merger of the two companies ' operations, which are not part of the control premium. The reason for the control premium is that after the acquirer has restructured, the expectation is that by controlling the business development and direction selection of the acquired enterprise, it may affect the time and amount of the future cash flow, even the local strategic loss for the overall benefit, which can be based on the buyer's own understanding, such as Baidu potential holding good doctor, Ali wholly-owned acquisition of gold, control of course is determined by the controlling party.

At the same time, this problem is discussed because in the specific valuation and investment behavior occurs, not every enterprise is a mess, some companies will continue to stabilize profits, cash flow is abundant, when you want to strong alliances or "Snake swallow Elephant" time, may need to pay a part of the price. Of course, the exact amount of the purchase will be on both sides, but even in the case of a control premium, valuations usually do not exceed the company's most optimistic ceiling.

Here is an example of a financial approach to the control premium. "290" Company in 2013 financial year has 100 million Yuan EBITDA, currently in accordance with the value of enterprises in the industry about ebitda_5= RMB 500 million yuan. Our "260" Company is interested in acquiring it, "260" B classmate and chairman of T classmate after careful study, "290" company because of management general, its operating potential is far from playing out, if they operate by them, EBITDA can definitely increase to 150 million yuan, therefore, "290" The company's potential value should be RMB 750 million (150 million _5), after management reorganization, the integration of "260" Company's cash management experience, the value of its management should be about equal to 50 million yuan of EBITDA.

In turn, it will be converted to a control premium of RMB 250 million (50 million pocket or 750 million-500 million) yuan. So when the "260" of B students commissioned show Red Capital of a classmate to do the acquisition of consultants, try to 500 million yuan for the first round of quotes, was "290" refused. But the "260" maximum bid will not exceed 750 million yuan, because both sides are not urgent, so in the "you shoot one of me," the bargain process, gradually reached a consensus.

Therefore, the control premium is inversely proportional to the ability of the management of the company being acquired. The lower the management level of the acquired enterprise, the higher the value of the control power. On the contrary, the higher the level of enterprise management, the lower the value of control rights. Therefore, the value of control is the value of the reorganized enterprise-the value before the reorganization. So if the acquirer can buy at least 51% per cent of the underlying company, the acquirer will have control of the company. The highest price that the acquirer is willing to pay includes the corresponding valuation of the shares, as well as the control premium approved by the acquirer.

Conversely, if the acquirer buys up to 49% or less, then it means that the acquirer is not under control, then the highest price the acquirer is willing to pay can only be calculated on the basis of the equity ratio, based on the valuation before the company's reorganization. Under normal circumstances, the participation is mostly financial investment, holding more for strategic investment or industrial mergers and acquisitions. There are also some companies in the acquisition of the offer, if not up to the holding requirements, they will abandon the entire acquisition plan, like the acquisition of the company to a "full or none" valuation offer.

So there is a huge difference between 51% and 49% of the company's equity, and we often see hostile takeovers, poison pill plans, and whatever you can do to alliances or "hold cards" in business novels or movie dramas. Art comes from life, and when the control premium is known, small partners can understand more deeply what is being expressed in these works. For example, the recent Fosun bid to privatize the acquisition of "U.S.-China mutual benefit", intended to integrate the "Harmony Home", and Fosun's overall medical layout synergy. In the scramble for control, Carlyle and Chun Hua Capital were involved in the bid. Carlyle is likely to be the subject of a takeover, floating on the water to buy, when the time is ripe to transfer, because the private sector itself can not run the business. And the spring capital is likely because of a large amount of funds has just been raised, and finally found a suitable bid, want to quickly put the money to invest in the hands.

This actually dr.2 conjecture that the final results might have the following:

1, if the "Harmony family" shareholders do not want to withdraw all, but only the transfer of control, then the use of swap and cash mode, Fosun increased the likelihood of successful acquisition.

2, if the "Harmony House" shareholders want to withdraw all, no longer holding shares and accept a full cash offer, it should be the highest bidder, the spring and Carlyle will win the probability of greater.

3, do not accept, continue to choose to operate independently, then, as a result of the privatization of Fosun contract defaults, the need to pay a lot of liquidated damages, the probability is relatively small. This shows that the industrial capital and VC/PE are often fierce game.

There is also the question of a preferred stock, which is also a manifestation of a control premium, of course some preferred stock also includes priority to obtain liquidation rights, priority dividends, etc., this is not discussed. For example, the issue of different voting rights for A/B shares in the US stock market is centred on the protection of Management's board of directors rather than the capital side.

Facebook's Zuckerberg-owned class A shares 10 times times the vote on common stock, which theoretically allows him to retain control of the company if he has at least 9% preferred shares. Even Google and other companies have designed 1:20 of the preferred stock of voting rights to ensure that control does not leave hidden dangers. The Hong Kong listing of the law to share the same rights, China's Shanghai and Shenzhen stock market, the preferred stock reform has just begun, which is Ali to abandon Hong Kong, the direct reason to choose the U.S. listing. Then we can naturally find that the value of A/B shares is different. In terms of the control premium alone, the preferred shares, which have 10-20 times the right to vote, may be several times the price of common stock.