Regarding Fairness Opinions Pros Ask, What’s Fair?

A recent report reignited the debate around fairness opinions with claims that new empirical evidence proves conflicts of interest do in fact exist.

The examination into "what is fair?" is by no means new. In fact, as long as companies have been bought and sold, onlookers have been questioning the methods used to determine valuations. But since 1985, when the Delaware Supreme Court ruled against Trans-Union Corp. (decreeing that the company's board was negligent in its sale to the Pritzker family), most public companies have sought out fairness opinions as a shield against litigation.

Questions, though, still surround what is motivating the banks providing these opinions. If they are indeed being brought in to "rubber stamp" a deal, then would it be good practice to impede the deal's progress? Or, even worse, if the banks are involved in other parts of the transaction, such as the financing, would they risk those fees by declaring a transaction "unfair?"

According to a new report out of the "Charles A. Dice Center for Research in Financial Economics," fairness opinions are impacted by these diverging agendas. Rajesh Narayanan, a professor at the University of Georgia, co-authored the report with Anil Makhija, of The Ohio State University. While he concedes that the research is a work in progress, Narayanan tells M&A that out of the deals the pair looked at (a sampling of 1,927 transactions from 1980 to 2004), companies that didn't employ fairness opinions typically fetched higher premiums than those that had brought in outside help.

Narayanan says that on average, when banks provided an opinion, the target companies reached a premium that was 48% above their share price going into the deal, versus a 54% premium when no fairness opinion was provided.

"The banks are brought in to find a price at which they can get the deal done," Narayanan says. "But they don't necessarily tell you if a company can find a better price."

Not everyone feels that the "rubber stamp" label applies. Matthew Herman, an M&A partner at Freshfields Bruckhaus Deringer in New York, cites that a key factor to consider is the timing of when fairness opinions are provided—often at the end of long and arduous negotiations.

"Fairness opinions don't exist in a vacuum," he says. "While it may look like the banks simply dial it in, the process is not normally that binary—an opinion is delivered following the result of what is likely a considered amount of back-and-forth between target and buyer, throughout which the target has been in constant contact with its legal and financial advisors."

If a deal is in fact "unfair," that determination, Herman implies, would be discovered well before it's time to deliver the actual fairness opinion. Moreover, Herman notes that "nobody knows what 'fairness' really means."

"It clearly doesn't mean the 'best price,'" he says. "Rather it is a statement of the financial adviser that the deal consideration is within a range of financially fair values. What is fair is based on a range of input data and financial analysis, with the somewhat subjective process not being as objective as say, whether a car passes an inspection."

Still, Herman notes that it's unlikely two banks, working with the same data, would arrive at "vastly different" opinions.

Any solutions?

The regulators finally weighed in on the debate in October, and after years of analysis, issued a concrete ruling (NASD Rule 2290) that broadly calls for more disclosure. The directive, which was proposed by the National Association of Securities Dealers in 2005 and amended four times since, now forces member firms to disclose if they will receive a "success fee" at the completion of the deal, and also make public whether or not they have had other relationships with the target company, be it as an intermediary or lender. The ruling also requires member firms to incorporate in writing the procedures used to develop the opinion, and it also helps identify whether the fairness opinion is expressing a view on the amount or nature of compensation that company management is receiving.

While more disclosure will help erase some doubts surrounding fairness opinions, some critics feel the ruling will fall short of having any real impact. Steven M. Davidoff's M&A Law Professors Blog, for instance, surmised in a post that the ruling had been "watered down into meaninglessness."

UGA's Narayanan, meanwhile, cites his research, noting that when fairness opinions were provided by "independent" advisers, the average merger premium was higher than deals that included opinions from banks with previous or ongoing relationships. However, Narayanan isn't ready to say independence should be required. "There is the chance that a current adviser, if they're intimately involved with the company, knows more about its true value."

According to a pro at a mid-market investment bank, one solution that has become more common is to bring in two or sometimes even three advisers to provide a fairness opinion. "There's been a fairly significant increase in the number of second opinions," the banker says, estimating that he sees it in roughly one out of every four deals. "It's a perfect solution as long as the advisers are disinterested and not involved in the deal."

But Herman notes that it is ultimately up to the banks to do what's right. And he says it is unlikely that any reputable bank would risk its name providing a bunk opinion. "There is no single deal fee in the world that that's more valuable to a major firm than their name," he says.