When to Use Fairness Opinions in Private Transactions

Disagreements about valuations are a dime a dozen — and fairness opinions can be a great way to preempt any dispute-turned-lawsuit.

Most often, fairness opinions are associated with public transactions. As John Leo of Primary Capital explained, “It is a business dominated by public companies because the real defining issue is whether or not minority shareholders are receiving fair value and being treated in an equitable manner.” He continued, “In order to address the [potential] conflict, companies get a fairness opinion from an independent third party; it is really an insurance policy.”

However, while the majority of fairness opinions are still conducted for public transactions, an increasing number are being employed in middle market private transactions as overall deal-related litigation is on the rise.

Two transactions that can often benefit with the presence of a fairness opinion are Employee Stock Ownership Plans (ESOPs) and control recaps.

ESOPs

One of the most common private transactions to utilize fairness opinions is the ESOP. As Matthew Morris of RGL Advisors recently explained, “In an ESOP, the employees of the company typically receive stock holdings in the company as part of their compensation for work performed. Shares are held in trust until the employee retires or leaves the company, at which time the shares are sold. A trustee is designated to represent the interests of the ESOP trust and votes in business matters on behalf of the ESOP trust and its employee beneficiaries.”

Because there is one trustee managing multiple shareholders, the execution of a fairness opinion can be particularly important. Morris continued, “When an offer for a purchase or merger is made, the trustee must exercise fiduciary duty on behalf of the ESOP. In these transactions, the risk of dispute can be higher than a private company deal involving just one or two shareholders. A fairness opinion can help demonstrate that fiduciary duty was executed in good faith and can reduce the chance of shareholder dispute resulting from the transaction.”

As the acquisition of ESOP-associated businesses becomes more popular among middle market PE firms, the understanding and use of fairness opinions is more critical.

Control Recaps

Another private transaction that often warrants a fairness opinion is a control recap. “Control recaps give the private equity firm a controlling interest in the company, but leaves a substantial shareholder in play,” explained Morris. “While this might be financially or strategically prudent at the time of the investment, in a subsequent sale, the process of separating financial interests can be made more complicated.”

He continued, “This is particularly true if there is a disagreement between the majority and minority shareholder(s) about the terms of a transaction. Again, the fairness opinion can help demonstrate the exercise of fiduciary duty to better withstand subsequent challenges.”

Leo agreed, “As more and more private companies move up the food chain and attract private equity investors, it would be prudent to get a fairness opinion when they do a similar transaction.”

But, there’s more…

While Leo agreed that fairness opinions were more relevant for certain middle market transactions, they should be a consideration for nearly any deal. “If there is any potential conflict of interest, it’s always prudent to get a fairness opinion. Any M&A transaction where the issuer is purchasing or selling an asset from/to a related party should include a fairness opinion,” he explained. “The related party could be an officer, a director, large shareholder, or an affiliate.”

While it may seem like a burden at the time, “If you are doing an acquisition under $100 million, it is typically going to be much more financially efficient to pay for a fairness opinion upfront rather than have a legal battle later on with a handful of shareholders that dispute the value of the transaction,” explained Leo. “If you go to court with multiple shareholders, you will have to face several law firms and can easily incur hundreds of thousands of dollars in legal fees.”

Despite the time and cost that may be associated with a fairness opinion, it will be the better alternative to any legal battle.