In re Appraisal of SWS Group, Inc., C.A. No. 10554-VCG (Del. Ch. May 30, 2017) (Glasscock, V.C.)
In this post-trial appraisal opinion, Vice Chancellor Glasscock, relying on a discounted cash flow analysis, held that the fair value of SWS Group, Inc. (“SWS”) at the time of its January 2015 merger with a wholly-owned subsidiary of its creditor Hilltop Holdings, Inc. (“Hilltop” and, together with SWS, “Respondents”) was $6.38 per share. The Court’s determination represented a substantial discount to the $6.92 per share cash and stock consideration SWS stockholders received in the transaction. The Court’s determination, was, in the Vice Chancellor’s estimation, “not surprising” given that the deal was “a synergies-driven transaction” in which the acquirer shared value arising from the merger with SWS.
In reaching its decision, the Court did not defer to the deal price for two primary reasons. First, neither party relied on the deal price to establish fair value. Petitioners argued that the sales process was so flawed that deal price was irrelevant while Respondents argued that deal price was improper because it included large synergies inappropriate to statutory fair value. Second, the process leading to the merger, including the probable effect on the deal price of the existence of a credit agreement between SWS and Hilltop as well as Hilltop’s exercise of partial veto power over competing offers, rendered the merger price an unreliable indicator of fair value.
The Court also gave no weight to the comparable companies analysis proffered by Petitioners’ expert, finding it unreliable because the companies selected by the expert were not truly comparable to SWS and, rather, “diverge[d] in significant ways from SWS in terms of size, business lines, and performance.”
For its own discounted cash flow analysis, the Court began with the SWS management’s cash flow projections. The Court noted that management routinely prepared three-year projections. Petitioners’ expert extended the projections another two years on the theory that the company would not reach a “steady state” in three years and, therefore, applying a terminal period after five years would better capture its future performance. The Court rejected the adjustment, finding Petitioners’ reasoning for doing so unsupported by the evidence. For example, the Court noted that the extended period reflected unlikely and “unprecedented straight-line growth, reaching a profit margin far exceeding any management projections, despite the Company’s structural issues and performance problems.”
The Court made a number of determinations regarding certain inputs to the DCF analysis. First, it addressed whether a 2014 warrant exercise should be considered as part of the company’s “operative reality” at the time of the merger and whether any excess regulatory capital SWS held as a result should be distributed in the valuation model. On the first point, the Court held that the warrant exercise was part of the company’s operative reality because the warrants were exercised before the merger to enable holders to vote for the transaction. The Court held that the resulting capital change, however, would not lead to a distribution of excess regulatory capital to the stockholders. In support of this latter conclusion, the Court noted that management’s projections contemplated the warrant exercise in 2016 but not a resulting distribution. The warrant exercise did, however, result in a reduction to the company’s interest expense and, therefore, a resulting increase to management’s projections of net income.
The Court adopted Respondents’ proffered terminal growth rate, 3.35%, the midpoint between the long-term expected inflation rate (2.3%) and the long-term expected economic growth rate of the economy at large (4.4%).
Both parties used the Capital Asset Pricing Model to calculate the cost of equity. The parties agreed that the risk free rate of return is 2.47%, but disagreed on the equity risk premium, equity beta and size premium.
With regards to the equity risk premium, the Court adopted Petitioners’ use of the supply-side ERP, finding no basis to deviate from the Court of Chancery’s recent trend of employing the supply-side instead of a historical ERP.
The Court also adopted Petitioners’ beta, which their expert derived using multiple data points including by reference to comparable company returns. The Court rejected Respondents’ use of a two-year weekly lookback from the date of Hilltop’s initial offer because it covered times where a “merger froth” and corresponding volatility were likely reflected in the trading and pricing of SWS stock.
Both parties’ experts employed Duff & Phelps as the source of their size premium, but they disagreed on which decile SWS fell within. The Court held that both Petitioners and Respondents presented persuasive evidence for their position and split the difference down the middle, using the mid-point of the expert’s approaches.
After reaching the foregoing determinations on the inputs to the DCF analysis, the Court held that the fair value for SWS shares at the time of the merger was $6.38 per share.