October 01, 2012

Gearreald v. Just Care, Inc., C.A. No. 5233-VCP (Del. Ch. April 30, 2012) is an appraisal proceeding brought pursuant to 8 Del. C. § 262. The former shareholders and managers of a prison healthcare detention company, Just Care, Inc. (“Just Care” or the “Company”), sought an appraisal of their shares following an all cash acquisition of the company for $40 million. This case is a classic battle of the valuation experts, whereby the Petitioner’s expert asserted that the Fair Value of the Company was $55 million, and the Respondent’s expert determined a Fair Value of $33 million. Ultimately, the Delaware Chancery Court (the “Court”) concluded on a Fair Value of $34 million, which was $6 million less than the cash acquisition price.

As with most of these cases, the differences between the conclusions of the two experts boiled down to a couple of key issues. This article explores those issues and the Court’s related analysis and reasoning.

Background

Just Care operates as a private healthcare detention facility that provides an alternative to hospitals for the care of sick, aging, and mentally ill inmates and detainees. Petitioner Gearreald was the founder, former CEO, and a director of Just Care. Before the merger, Just Care was controlled by majority shareholder Maxor National Pharmacy Services Corp. (“Maxor”). Representatives of Maxor received unsolicited interest from Nonparty GEO Care, Inc. (“GEO”) with respect to the acquisition of Just Care in November 2008. In May 2009, the board approved moving forward with negotiations with GEO and formed a Special Committee, which retained counsel and an independent financial advisor. Ultimately, in August 2009, the Board unanimously approved an agreement plan of merger between Just Care and GEO.1 The deal closed in September 2009 after the shareholders approved the merger. However, 65 of the Company’s 115 shareholders – about 36% on an as-converted basis – voted against it.

Legal Question at Hand

The Court began its analysis of the case by setting out that an appraisal action is a “limited legislative remedy which is intended to provide shareholders, who dissent from a merger asserting inadequacy of offering price, with an independent judicial determination of the Fair Value of their shares.” The Delaware General Corporation Law (“DGCL”), under 8 Del. C § 262(h), entitles Petitioners to their pro-rata share of the Fair Value of the company in question as of the merger date. Fair Value takes into account all relevant factors known or knowable “as of the date of the merger that illuminate the future prospects of the company.”2 In addition, the court must determine the Fair Value of the company to the stockholder as a “going concern.”3 Determining the value of a “going concern” requires the court to exclude any synergistic value; that is, “the amount of value the selling company’s shareholders would receive because a buyer intends to operate the subject company, not as a stand-alone going concern, but as part of a larger enterprise, from which synergistic gains can be extracted.”4

Valuation Analysis

Both of the parties’ experts rejected a precedent transactions analysis based on the reasoning that, if unadjusted, this method may inherently capture anticipated synergies from the transaction. Respondent’s expert gave some weight to a guideline company method based on an analysis of comparable public companies. However, the Court rejected reliance on this method. Citing that Just Care is a company with a unique business model, the Court stated that it only considered the results of this method “in the sense that it lends support to the final valuation arrived at in the Opinion.”

Each of the parties’ experts relied primarily on the discounted cash flow (“DCF”) method to value the Company, which is where the Court focused its attention to reach its conclusion. More specifically, the Court focused on the following primary areas of conflict between the experts: 1) the Company’s projected cash flows; and 2) the capital structure, equity risk premium, and size risk premium assumptions utilized in the calculation of the weighted average cost of capital (“WACC”).

Company Cash Flow

Both experts relied on management prepared projections to perform their DCF analyses, although the Respondent considered such projections aggressive.5 Management prepared three versions of the projections: 1) the Static Case; 2) the SVP Case; and 3) the Georgia Case. The SVP Case was premised on the Static Case, plus adding on to the Company’s existing Columbia, South Carolina, facility to house 60 additional inmates. The Georgia Case included the Static Case and SVP Case plus an additional expansion into a prison center in Georgia.

The Respondent’s expert placed partial weight on the Static Case and the SVP Case, but excluded the Georgia Case due to the speculative nature of this expansion. The Petitioner’s expert placed reliance on all three cases. The Court ultimately sided with the Respondent on this issue based on the evidence presented that expansion into Georgia was speculative at best, particularly given the Company’s lack of history of expanding beyond its single location and given all of the hurdles that would need to be overcome to open a financially successful new facility in another state. The Court stated that the Company must be valued as a going concern based on the operative reality of the Company as of the merger date based only on what was known or knowable. The Court distinguished Just Care from the decision reached in the Open MRI Radiology Associates6 case whereby expansion plans were considered in the valuation analysis due to the fact that the subject company was executing a visible plan of expanding its network statewide, leading the Court to analogize the subject business to a McDonald’s or Starbucks.

Weighted Average Cost of Capital

Capital Structure

The WACC is estimated in the application of the DCF method in order to calculate the present value of the future cash flows of the subject company. One of the inputs in the calculation of the WACC is the assumed percentage of interest-bearing debt, preferred stock, and common equity in the subject company’s capital structure. The Respondent’s expert determined a capital structure of 100% common equity to be appropriate based on the Company’s actual capital structure immediately prior to the merger. However, this actual capital structure was impacted by the merger in that immediately prior thereto, pursuant to the merger agreement, the Company was required to pay off its debt and convert its preferred stock to common stock.

The Court rejected the Respondent expert’s assumption due to the fact that the capital structure applied “arose directly out of an expectation of the merger.” Thus, the Respondent expert’s assumption violated the valuation premise that Fair Value was to be determined on a going concern basis without regard to the impact of the actual merger itself. The Court concluded that the correct capital structure for an appraisal of Just Care is the theoretical capital structure it would have maintained as a going concern. This was the premise utilized by the Petitioner’s expert.

Equity Risk Premium

Both of the experts utilized the capital asset pricing model (“CAPM”) to determine the cost of equity capital, which is one of the major inputs in the calculation of the WACC. Two of the major elements of the cost of equity determination utilizing the CAPM are the equity risk premium and the size risk premium.

The Petitioner’s expert relied on a supply side equity risk premium of 5.73%, whereas the Respondent’s expert relied on a historical equity risk premium of 6.47%. The Respondent’s reasoning was that the historical equity risk premium has been the industry standard and that the Petitioner’s expert himself has used this equity risk premium in the past.

Citing Global GT LP v. Golden Telecom, Inc.,7 the Court noted that “although experts and this Court traditionally applied the historical equity risk premium, the academic community in recent years has gravitated toward greater support for utilizing the supply side equity risk premium.” Chancellor Strine’s decision is quoted out of this case on the issue:

“when the relevant professional community has mined additional data and pondered the reliability of past practice and come, by a healthy weight of reasoned opinion, to believe that a different practice should become the norm, this court’s duty is to recognize that practice if, in the court’s lay estimate, the practice is the most reliable available for use in an appraisal.”

As such, the Court adopted the supply side equity risk premium in the instant case.

Size Risk Premium

The size risk premium is added to the calculation of the cost of equity to account for the higher rate of return required by investors because of the greater risk associated with relatively smaller companies. Both experts agreed that a size risk premium was appropriate, and they both agreed that by size alone, Just Care falls within Ibbotson’s8 reported decile 10b. The size risk premium for this decile was 9.53% and was relied upon by the Respondent’s expert.

The Petitioner’s expert applied a lesser size premium of 4.11% based on Ibbotson decile 10a, which includes a group of companies larger than those included in decile 10b. The reason cited by the Petitioner’s expert was that decile 10b contains a “well documented liquidity effect” which is akin to a “liquidity discount” and that such discount “must be eliminated in a Fair Value determination – much like a discount for lack of marketability or minority interest.”

Based on case law precedents, a general liquidity discount is not typically applied in an appraisal proceeding as “such a discount generally relates to the marketability of the company’s shares and is therefore prohibited.” However, the Court also notes that “although a liquidity discount for marketability of a company’s shares is prohibited, that does not mean that the use of any input that is correlated with a company’s illiquidity is per se invalid.”

Putting this logic to the case at hand, the Court reasoned that “there is a liquidity effect in relation to transactions between Just Care and its providers of capital and, as such, is part of the Company’s value as a going concern. When a company’s illiquidity affects its ability to obtain financing for its operations, the company’s overall risk and return profile will be effected (i.e., the company will be worth less as a going concern because its financing costs are higher).” The Court concluded that this liquidity effect should be included in calculating Fair Value due to the fact that it relates to the Company’s intrinsic value as a going concern. This is in contrast to the illiquidity effect (or discount for lack of marketability) that is generally prohibited under Delaware appraisal law, which relates only to the ability of an investor to exit his investment by selling shares in the open market.

For these reasons, as well as the Court’s finding that the Petitioner’s expert’s “methodologies for removing the liquidity effect from the size premium are novel and have not been peer reviewed,” the Court sided with the Respondent’s expert’s conclusion with respect to the size risk premium.

Conclusion

This case presents a number of interesting twists that demonstrate the importance of counsel and the valuation expert working closely together to present an analysis that is supported by the law as well as the latest financial/valuation theory. Ironically, the transaction terms in the merger agreement included the requirement of a $6 million reserve to cover post-merger costs, including successful appraisal challenges. In essence, the Just Care shareholders who accepted the $40 million bid were able to keep the money they received at a price based on that offer, but the dissenters received a lower price based on the Court’s $34 million appraisal conclusion. The Court concluded that “the escrow provision is immaterial to the determination of Fair Value in this appraisal action and that therefore, the dissenting shareholders must prove that the value of the Company was greater than $40 million at the time of the merger in order to receive additional consideration from the escrow account.”

For the reasons summarized in this article, the Petitioner was unsuccessful in convincing the Court that the Fair Value of Just Care was greater than $40 million.

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1 Petitioner Gearreald voted in favor of the merger as a director.

2 8 Del. C. § 262(h); Weinberger v. UOP, Inc. 457 A.2d 701, 713 (Del. 1983) (quoting Tri-Continental Corp. v. Battye, 74 A.2d 71, 72 (Del. 1950)).

3 M.P.M. Enters., Inc. v. Gilbert, 731 A.2d 790, 795 (Del. 1999); accord Technicolor, 684 A.2d at 298 (“[T]he Court of Chancery’s task in an appraisal proceeding is to value what has been taken from the shareholder, i.e., the proportionate interest in the going concern.”)

4 Union Ill. 1995 Inv. Ltd. P’ship v. Union Fin. Gp., Ltd., 847 a.2d 340, 356 (Del. Ch. 2004).

5 The Court noted that because such projections were prepared by management in the context of litigation, that such projections were not entitled to the same level of deference as those projections contemporaneously prepared by management in the ordinary course of business.

6 Cf. Del. Open MRI Radiology Assocs., P.A. v. Kessler, 898 A.2d 290, 315 (Del. Ch. 2006).

7 993 A.2d 497 (Del. Ch. 2010).

8 Morningstar, Inc. publishes a reference book – Ibbotson’s Stocks, Bonds, Bills, and Inflation Valuation Yearbook that is commonly used by valuation professionals for information on equity risk premiums and size risk premiums.