ASC 820 – Fair Value Measurements and Disclosures sets forth the definition of Fair Value as “The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date”. Paramount to the definition is the concept of the “Market Participant”.
The Market Participant is further defined in ASC 820 (SFAS No. 157) as “…buyers and sellers in the principal (or most advantageous) market for the asset or liability that have all of the following characteristics:
2. Knowledgeable, having a reasonable understanding about the asset or liability and the transaction based on all available information, including information that might be obtained through due diligence efforts that are usual and customary.
3. Able to transact for the asset or liability.
4. Willing to transact for the asset or liability (that is, they are motivated but not forced or otherwise compelled to do so).”
A Market Participant will fall into one of three categories; a buyer who is in the same business segment of the industry as the taret, to the extent that the buyer provides the same service or product; a buyer who is in the same general market place or industry with the target, providing ancillary products or services, that wishes to enter into the same business segment as the target; or a purely financial buyer, an example of which is a private equity group.
The Market Participant Rate of Return (“MPRR”) is the return required by the Market Participant to enter into the investment. Where does one look for a proxy for the MPRR? Might firms in the same industry as the subject of the appraisal be considered Market Participants? Are actual bidders in the auction process on the purchase of the entity Market Participants? What about firms contacted by the investment banker for the seller? What happens when the acquired entity was purchased in a stressed situation or without the auction process? The facts and circumstances of each engagement must be assessed when answering these questions.
One method used to estimate the MPRR is to assess publicly-traded companies which are in the same two or four digit SIC code as the target. Entities reporting in the SIC codes will fit into the two categories of market participant that are in the same industry as the subject. The financial buyer will most likely look to this same pool of potential investors to aid in their determination of required return based on the return of the respective industry. Therefore, all three types of market participant buyers should be represented in the analysis.
After selection of the Guideline Companies, an estimate of the ‘market’ cost of capital is performed. Use of the CAPM build up method is typical, as many sources provide the requisite data to perform the exercise. Average industry weight of debt-to-equity is also readily available for most of the guideline companies and is typically used to weight the debt and equity. The resulting WACC determined using guideline companies as the proxy for the Market Participant WACC provides us with a “floor” return. The Market Participant will require a rate of return in excess of its cost of capital. This concept is fundamental to investment theory. The added risk of making an investment in the appraisal subject must be assessed and is based upon the perceived investment in it, in terms of size, risk profile, performance, and growth expectations.
Market Partcipant synergies and buyer specific synergies must also be addressed as they relate to the cost of capital. Will the addition of the appraisal subject allow for additional borrowing, thereby decreasing the cost capital? Does the combined entity have better access to capital? The ASC allows for Market Participant synergies to be considered in the determination of fair value, but not buyer specifc synergies. Buyer specific synergies are ultimately embedded in goodwill.
As the accounting world grapples with the application of the fair value standards and as companies attempt to apply the concepts, PCE stands ready to assist in the determination of fair value for financial reporting.