The Real Problem with Appraisal Arbitrage

Abstract

In the controversial practice of appraisal arbitrage, activist investors buy up the shares of a corporation to be acquired by merger in order to assert appraisal rights challenging the price of the deal – which may already have been approved by the target stockholders. The practice is controversial because the appraisal remedy is widely seen as intended to protect existing stockholders who are (or will be) forced to sell their shares in the merger – because the majority rules. But the real puzzle is why appraisal arbitrage is profitable since the goal of an appraisal proceeding is to determine the fair price of target shares using the same techniques of valuation used by financial professionals who advise the parties to such deals. Thus, commentators have argued that the profit derives from (1) a free option to assert appraisal rights at any time until target shares are cancelled (and indeed for short time thereafter), (2) the award of pre-judgment interest at a too-generous rate, and (3) the use of a too-low supply-side discount rate in the valuation of shares. As shown in this article, none of these explanations has merit, but the third may be on the right track in that it has become almost standard practice among appraisal courts to reduce the discount rate by the projected rate of inflation and general economic growth for the so-called terminal period beyond five years into the future. The fallacy in doing so is that the discount rate implicit in market prices already incorporates these factors because investors demand and expect returns commensurate therewith. While it may be appropriate to adjust the terminal period discount rate for company-specific growth funded by the plowback of returns at a rate implicit in projected terminal period cash flow, it is incorrect to assume that growth will simply happen in lock-step with the economy as a whole. Thus, appraisal arbitrage is likely encouraged by awards that are skewed to the high side by erroneous valuation practices.

Keywords: appraisal arbitrage, merger, valuation, discount rate, inflation, growth, option, pre-judgment interest, supply-side, equity risk premium, projection period, terminal period, discounted cash flow, plowback, DCF, capital asset pricing model, CAPM, fair price

JEL Classification: G34, K22, K41