Setting the scene

In the period following a buyout of the business in 2001 several of the founder shareholders had retired but had retained their shareholdings. This meant that there was an increasing misalignment of the management and ownership interests. However their close alignment was considered to be essential by various investors and was a core part of the business model of the company. 

At the heart of this case was an offer made for the shares of Charterhouse by a company set up by management for the purpose. Watling Street Limited. All the outgoing shareholders accepted the offer of £15.15 million in cash and loan notes for the entire share capital of the company apart from Mr Arbuthnott. 

Some of the points of contention

The case touched upon a number of major issues which often relate to actions brought under Section 994.

• Was the business a quasi-partnership?
• Can substantially the whole of the profits reasonably be extracted in the form of executive remuneration?
• Alternatively, should dividends be declared by the directors to those shareholders no longer working in the business?

There were also several fascinating valuation points which arose from the evidence of the two valuation experts, both of whom have impressive valuation pedigrees: 

• the definition of "market value" under International Valuation Standards 2011 and the exclusion of the special purchaser from that definition;
• the role of P/E multiples and Assets Under Management (AUM) valuation metrics when there are no directly comparable guideline public companies;
• the valuation of any business which has minimal profits once remuneration and bonuses have been paid to the management team;
• the requirement for multivariate regression modelling in order to avoid a charge of naivety;
• the use of discounted cash flow techniques as a cross check or alternatively as the sole approach to the valuation and;
• the role of the control premium in valuation.

Delightful ironies

The first irony was that private equity businesses, engaged as they are in the art of buying and selling businesses successfully, were described by a private equity expert as the most difficult type of business in the world to sell.

The second irony is that the managers and shareholders involved in this case all recognised that they were very skilled at valuing businesses; however a great deal of importance was centred on the evidence of two external valuers, who produced two very different valuations for the entire company.

The valuations

There was certainly no alignment in the views of the valuers. One valuer derived a value in the range of £275m to £321m; the other valuation expert valued the entire shareholding at £20m to £25m.

The valuer for Mr Arbuthnott applied a Price-to-Earnings (P/E) approach, using four guideline companies. He then looked at the assets under management and applied a valuation metric based upon this measure. Lastly he used a discounted cash flow approach as a form of cross check. He also made assumptions regarding certain changes to the business model including the carried interest which he assumed would remain partly within the company. He applied a control premium and also a discount to allow for the fact that this was a private company.

The valuer for the defendants was critical of the use of P/E ratios on the basis that none of the guideline companies were comparable; he was even more critical of the metric based on assets under management as this had no regard to the relative profits deriving from such assets. In evidence he described this approach as, “particularly unhelpful.”

He used a Discounted Cash Flow (DCF) approach in order to derive his far lower value, using cash flows derived from four specific sets of assumptions. He also made the points that various forms of profits multiplier were in essence simplified DCF approaches.

The decision

The judge much preferred the position of the defendants. As other outgoing shareholders, each of whom was financially sophisticated, had accepted the offer which valued Charterhouse at £15.15 million, this was compelling. The valuer for Mr Arbuthnott, holding to a far higher value, was clearly always likely to be in some difficulty against this background.   

The control premium

There continues to be a very sharp contrast between some of the views in the UK and the USA regarding the control premium. It seems that the two valuation communities are well out of alignment. The expert for Mr Arbuthnott had added a 40% premium to the guideline public companies. This was based on the transactions in the market spanning five quarters prior to the transaction. A Big 4 firm had previously valued the business and had applied a control premium of 39%. The other expert agreed that it was very important to include an uplift for control when valuing by reference to listed companies.

I will contrast this with a statement by Eric Nath in 2011: "… it is surprising that so many business valuers still cannot understand why public company shares do not trade as minority interests, and why it is bad practice to add a control premium when valuing a private company using public company data."

There is further irony in this case. Dr Aswath Damodoran was cited by one expert as a source of valuation guidance. This is the view of Dr Damodaran on the control premium. “The value of control can be zero if a firm is already optimally run.”
Will we see a change of view in the UK in the near future?

Andrew Strickland, Corporate Partner, Scrutton Bland
Valuation Group, August 2014