Control premium in simple English

Quite often we hear about the term control premium in the context of takeovers and mergers. In this article, we will examine why a control premium is paid in successful takeovers and how this premium is reflected in a valuation. We will also provide some insights into measuring the premium being offered in an off-market takeover.

What is a control premium and why does it exist?
A control premium is an amount that a buyer is willing to pay over the current market price of a publically traded company.

Shares traded on stock markets like the Australian Securities Exchange are usually in minority parcels representing a very small portion of the total number of issued shares of a company. Investors trade these shares because they like the earnings profile, the dividends or the potential capital gains. Such investors are generally passive, without influence over the company’s decision making process. If they disagree with company management, other than asking a few questions at the annual general meeting there is little they can do apart from selling their shares.

In a takeover, the acquirer usually tries to acquire 100% of the company so that it becomes a private enterprise, or alternatively, to gain a controlling stake in the company (over 50% of voting power). The acquirer’s motives may include a belief they can run the company better than existing management or that the business and operations of the target compliments the acquirer’s business, generating synergy. Alternatively, the target may simply be a good buy.

Once an off-market takeover offer is announced or even rumoured, the share price of the potential target usually rises. This is because when a company is subject to a takeover offer, the acquirer is expected to pay more than the share market price in order to acquire the control. The premium generally reflects the benefits associated with gaining control, such as access the target’s cash flows, rationalising the workforce (subject to relevant laws) or controlling the strategy and operations. The increase in share price can also be driven by supply and demand, as this is generally when hedge funds move in from a speculation perspective.

In a successful takeover, the target company’s share price gradually moves towards the takeover offer price as the uncertainties relating to the takeover are eliminated. These uncertainties may include:

• Obtaining major shareholders agreement
• Gaining 90% acceptance in order to trigger compulsory buy out (full privatisation)
• Obtaining approvals from regulatory bodies such as the Australian Consumer and Credit Commission (ACCC) and foreign investment board
• Satisfaction of due diligence.

How is the control premium reflected in a valuation?
The independent expert’s reports prepared for off-market takeover offers or control transactions generally address the control premium concept in a few ways as follows:

Valuation on 100% basis
The expert is required to value the takeover target on a 100% or control basis and compare it to the value of consideration offered by the bidder. If the capitalisation of earnings methodology is used to value the target, the trading multiples of a basket of comparable companies and the implied multiples of comparable transactions are generally examined. As discussed above, the share market prices reflect minority parcels of shares. Accordingly, the trading multiples of the comparable companies calculated do not reflect a premium for control. When valuing the target on a 100% or control basis, the expert needs to incorporate a control premium which is commonly reflected in the multiples used in the valuation. 

The experts conclude the level of control premium used by using empirical evidence based on historical successful takeovers which states that the control premium is generally between 20% to 40%. This wide range is due to the actual premium paid in successful takeovers being influenced by:

• the number of bidders – if there is more than one bidder, the offer price is generally higher
• the potential synergies to be extracted from the transaction - the synergies can be operational or administrative overhead savings. The greater the potential synergy, the more the bidder is willing to pay. However, the value of synergies is generally divided between the acquirer and the vendors.

The method in which data is collected can also influence the level of premium observed. For example, the control premium is generally calculated based on the final takeover price as well as the target’s share market prices prior to the takeover announcement.

Implied transaction multiples
Another area experts usually reference is the implied multiples of successful transactions. However, one must exercise caution as such transactions are historical. With the market dropping substantially since its peak in 2007 and companies revising their earnings outlook, we are now in an entirely different market. So it is important not to use information on transactions completed in late 2007 to value a company today. Further, the transaction multiples may reflect different levels of synergistic benefits (in addition to control premium) paid for by the acquirers.

Potential cost savings
Another factor which may affect the level of control premium applied is potential cost savings in privatising the target company. This can include costs associated with the listing status of the company (ASX fees, costs of the annual general meetings, printing of the annual report, etc). When valuing the target on a 100% basis, these costs are generally excluded. Certain experts adjust these costs at the earnings level, whereas some reflect these savings in the control premium. Both methods are acceptable but the former provides more transparency.

How to measure the control premium being offered by the bidder
Apart from assessing whether a takeover offer is fair, the expert is required to quantify the potential control premium being offered by the bidder. In this regard, the expert generally compares the value of the consideration offered with the share market prices of the target prior to the announcement of the takeover offer. The expert usually calculates the volume weighted average price (VWAP) of the target over several periods prior to the takeover announcements in order to minimise the impact arising from short term share price fluctuations and speculations.

Control premium paid in a volatile market
The stock markets around the world have been experiencing one of the most volatile periods in recent history. Many wonder if this volatility will affect control premium levels. The Corporate Finance team at Grant Thornton have examined the control premium paid in successful takeovers in Australia since November 2007 and observations indicate that the level of control premium paid will most likely be in the 20% to 30% range, which is consistent with empirical evidence. Whilst there are a number of transactions with control premiums outside this range, no apparent trends have emerged.

Conclusion
Control premium is an integral component of a company’s value and ignoring control premium effectively undervalues a company. Despite the high level of volatility experienced by the Australian stock market, investors are still required to pay the same level of premium as they would have paid in stable market conditions. This shows that there is still value to be had in gaining control of a company.

Author: Robert Kwok and Andrea De Cian, June 2009

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