DE Chancery prefers supply-side ERP

If the recent Golden Telecom case was the first indication that Delaware courts are moving away from a historical equity risk premium (ERP), a new statutory appraisal action from the Delaware Court of Chancery confirms that a supply-side ERP may indeed be the courts’ preference, if not presumption. At issue was the merger of a private company that provided mental health services for state prison populations; the deal closed at $40 million, but a group of dissenting shareholders claimed the going concern value of the company was closer to $55 million.

Both parties’ experts used a capital asset pricing model (CAPM) to calculate a cost of equity, but the petitioners’ expert relied on a supply-side ERP of 5.73% while the respondents’ expert applied a historical risk premium of 6.47%, defending it as the “industry standard.” The court acknowledged its reliance on the historic ERP in the past, but then cited the following passage from Golden Telecom:

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 a result, the Delaware Chancery adopted the 5.73% supply-side ERP as the “appropriate metric to be applied in valuing the company.” Its decision also discussed the appropriate beta to use in the case and rejected a novel “liquidity adjustment” to the size premium. Read the complete digest of Gearreald v. Just Care Inc., 2012 Del. Ch. LEXIS 91 (April 30, 2012) in the August 2012 issue of Business Valuation Update; the court’s decision will be posted soon at BVLaw.