Transcending Fair Market Value

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Transcending Fair Market Value

“Beauty is in the eyes of the beholder.”

Margaret Wolfe Hungerford (née Hamilton), who authored many books, often under the pseudonym of ‘The Duchess’.

When I think about value, I (like most in my profession) think first about fair market value (“FMV”).  The classic definition of fair market value is:

The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.[1]

But the concept of value is complex.  It transcends FMV.

At its core, value is the measure of worth for a good or service expressed in monetary terms.  However, since the worth of a good or service varies from individual to individual and under different settings, there are many distinct types of value with distinct definitions (e.g., intrinsic value, fair value, fair market value).

Further, a common misconception is to think of value only in terms of the monetary benefits derived from the good or service, but it is really much more.  The value of a good or service also depends on all of the qualitative and intangible benefits that may not directly lead to a monetary benefit or may even have no monetary benefit at all.

If I buy a rare sports car for, say, $100,000, and I get to view it every time I walk into the garage, what is its value?  Arguably, its value to each buyer is $100,000 or more, or they would not buy it.  Its price is $100,000, and its FMV is $100,000 (assuming it was bought at arms-length in an active market), but I may have agreed to pay much more.  And what is the value of the pleasure I derive from the car, the drive, the fun, and its aesthetic beauty?  The psychological gratification to show it to and discuss it with friends?  How do you measure that?

Similarly, what about a painting on the wall?  It may go up or down in value, but you get to look at it every day.  Not too many people frame stock certificates, or bank statements.

This paper attempts to explain and distinguish between various valuation concepts, such as price, fair market value, fair value, liquidation value, intrinsic value, financial value versus strategic value, monetary versus economic value, emotional and psychic value, among others.  Environmental, social, and governance (ESG) value is relatively new, and gaining acceptance in corporate America.  Hedonic value has various meanings and uses but is usually thought of as the immediate emotional gratification (perhaps a cause for impulse buying), as contrasted to utilitarian value[2] (e.g., cars used exclusively for transportation).

Many people have heard of the cost, market, and income approaches to valuation, and these various approaches and hybrids can sometimes be applied to determining the different value standards mentioned above.  But while valuation (the process of putting a value on something) is part science and part art, there are well accepted techniques, methodologies, and theories that should be adhered to.  Valuation necessarily requires an understanding and deep insight into accounting, economics, and finance.  Now, statistical analysis, behavioral finance,[3] and cultural economics[4] are playing a more frequent role in valuation.

Fair Market Value

As the most common standard of value, it may be easiest to describe other value standards graphically as interrelationships and deviations from fair market value.  The plot below depicts utilitarian value against what I call cultural and emotional value.  Fair market value is generally high on the utilitarian scale (it represents the cash-equivalent price a buyer is willing to pay) and relatively low in cultural and emotional value.

Transcending Fair Market Value

Intrinsic and Fair Value

Intrinsic value can be related to psychic or emotional value but normally is thought of as the cash equivalent value (on a present value basis) to a specific owner.  That owner is usually the current owner and the value usually represents the value of the future cash flow, including the proceeds from a future sale.  Since taxes can be quite different in a sale (capital gains) versus income, normally an after-tax analysis is required to understand the scenario that may be more advantageous; hold versus sell.  But, once again, the owner may derive “satisfaction” and other rewards from being the owner/boss.  The tradeoff may be more than money, especially since the owner is incurring more risk.

I have placed the intrinsic value bubble above and to the right of FMV since the owner may have more time value (can realize income for more years and sell at a later date), all the while deriving more emotional or psychic benefits.

Fair value, like intrinsic value can certainly overlay (in the range of possible values) FMV and is normally calculated without regard to discounts associated with the lack of control and marketability.  The fair value of public stock is normally the same as its FMV.  In the case of closely held companies, the two can be markedly different because minority shareholders in private companies usually cannot sell their stock easily or control operations.

Transcending Fair Market Value

Liquidation, Monetary, Financial, and Strategic Value

 The liquation value is simply the FMV without the intangible assets of the business unless certain intangibles such as patents can be separately sold/licensed and utilized by another firm.  The monetary value is just what it says, pure cash value without regard to any psychic benefits.

To the typical private equity group (“PEG”), financial value rules – buy low and sell high.  It is all about cash-on-cash return.  A PEG usually requires higher returns (in part, to compensate for additional perceived risk since a seller will always know more than a buyer); therefore, the financial value is less than the expected monetary value (until they are a seller, of course).  PEG buyers also often look for market inefficiencies to achieve superior returns.  More often private equity buyers compete with strategic buyers (most often corporate buyers) in that revenue and cost savings synergies accelerate their value creation.

Transcending Fair Market Value

ESG and Psychic Value

Academic research has shown that incorporating environmental, social, and governance (ESG) considerations into the valuation of a company has (on average) a 9.8% increase on value.[5]  While adopting ESG can manifest into higher cash flows and/or growth for a company, we often see a significant portion of ESG value coming in the form of a reduction in the required rate of return (i.e., the cost of capital).[6],[7]  In fact, we see this reduction in the required rate of return bear out in the realized rate of return (i.e., the stocks of ESG companies have lower actual rates of return).[8],[9]  This begs the question: why do investors have a lower required rate of return for ESG companies?

It turns out that investors are willing to accept a lower rate of return when investing in ESG companies because of the non-monetary benefits they receive from investing in ESG companies.   The amount of additional benefit is buyer-specific, and while certainly related to the market price (FMV), the economic cost (which can be measured by how much return the investor is sacrificing for the given level of risk), plus the price paid would represent the total price the investor has in effect “paid.”  So, in my plot, I have placed ESG value to the right of FMV (higher cultural and emotional value) and below FMV (less utilitarian value).

Likewise, the sports car buyer or art collector is in a similar mode, getting to talk about the purchase, combined with the viewing pleasure (an additional attribute only relevant to physical assets).

Sports franchise investments often have similar characteristics.  Many do not make money, or at least not a fair return on investment.  In the case of certain franchises, though, the name recognition for the owner may lead to other opportunities that result in additional monetary value; or the owner may just derive a “psychic return” from the pleasure of being the owner of something so public and exclusive.

In fact, psychic return is a term of art in cultural economics.  It turns out that the actual returns on certain assets such as art are not commensurate with the risk inherent in holding the art (measured by their volatility over time in price).  It is this psychic return, the emotional gratification that comes from the ability to display, discuss (or brag), and view the art, which makes up for the missing return.

The sports car, fine art, and sports franchise examples may fall even farther than ESG value on the utilitarian axis, but to its right on the “psychic” scale.

Transcending Fair Market Value

On a more human and altruistic level, people all over the world work for less pay than their “opportunity cost” to take jobs that are psychologically rewarding.  Once I was asked to determine the economic loss associated with an injured, and scared, fashion model.  I recognized she lost more than her income; she lost the emotional rewards associated with being a model.  So, I conducted a survey to determine the amount of additional income it would take for the typical model to take a different job that she was qualified for, such as executive assistant (a job that today is almost obsolete) and added that to her lost income.

The Greatest of all Time (“GOAT”) Value

A paper on transcending value would not be complete without mention of the GOAT (aka, Tom Brady).  While Michael Jordan has arguably the greatest brand value in the history of sports, Tom Brady could compete for that valuation, should he want to.

Let us examine what has led to his value; Wins and Super Bowls!  And what has he done (other than be a great QB) to get there?  He has taken less than market salary and restructured his contract several times to surround himself by more expensive and presumably better teammates so that he can win.  So, he has derived huge psychic value at the expense of monetary value that could translate to enormous economic value, assuming he decides to fully monetize his success and fame.

Transcending Fair Market Value

I hope this short paper gets you thinking about the next major purchase, be it a business, a depreciable asset (like most cars), a perishable asset (such as a trip, although the psychic value created through memories can be high), or just something you have just always wanted.  In any event, it might give you some arguments with your significant other why you absolutely, positively need that sports car!

Questions and comments may be directed to Martin Hanan, CFA at 817-481-4900 or

Marty Hanan is the founder and President of ValueScope, Inc., a valuation and financial advisory firm that specializes in valuing assets and businesses and in helping owners and executives in business transactions and estate planning.   Mr. Hanan is a Chartered Financial Analyst and has a B.S. Electrical Engineering from the University of Illinois and an MBA from Loyola University of Chicago. 

[1]      Revenue Ruling 59-60, 1959-1 C.B. 237.

[2]      Babin, B., Darden, W., & Griffin, M. (1994).  Work and/or Fun: Measuring Hedonic and Utilitarian Shopping Value.  Journal of Consumer Research, 20(4), 644-656.  Retrieved March 26, 2021, from

[3]      “Behavioral finance studies how people actually behave in a financial setting.  Specifically, it is the study of how psychology affects financial decisions, corporations, and the financial markets.”  Nofsinger, J. R. (2002).  The psychology of investing.  Upper Saddle River, NJ: Prentice Hall.

[4]      “…cultural economics is defined as the application of economic theory to the cultural sector…”  Towse,Ruth, 2019.  “A Textbook of Cultural Economics,” Cambridge Books, Cambridge University Press, number 9781108421683.

[5]      Willem Schramade (2016) Integrating ESG into valuation models and investment decisions: the value-driver adjustment approach, Journal of Sustainable Finance & Investment, 6:2, 95-111, DOI: 10.1080/20430795.2016.1176425

[6]      Lasse Heje Pedersen, Shaun Fitzgibbons, Lukasz Pomorski, Responsible investing: The ESG-efficient frontier, Journal of Financial Economics, 2020, ISSN 0304-405X,

[7]      Guido Giese, Linda-Eling Lee, Dimitris Melas, Zoltán Nagy and Laura Nishikawa, The Journal of Portfolio Management, July 2019, 45 (5) 69-83; DOI:

[8]      Morningstar shows that portfolios of companies with lower ESG ratings outperforms portfolios with of companies with higher ESG ratings.

[9]      Lasse et al show that the lower returns are predominately from the environmental (E) and social (S) factors.  Higher ratings for the corporate governance (G) factor have been shown to result in superior returns.

Marty Hanan is the founder and President of ValueScope, Inc., a valuation and financial advisory firm that specializes in valuing assets and businesses and in helping business owners in business transactions and estate planning.  Mr. Hanan is a Chartered Financial Analyst and has a B.S. Electrical Engineering from the University of Illinois and an MBA from Loyola University of Chicago.

The information presented here is not nor should it be treated as investment, financial, or tax advice and is not intended to be used to make investment decisions.

If you liked this blog you may enjoy reading some of our other blogs here.

Update on Oil & Gas Royalties Litigation-Key Valuation Issues

Click to Download:  Update on Oil & Gas Royalties Litigation-Key Valuation Issues

Executive Summary

Issue:  When oil and gas prices are lower than expected, royalties go down.  This is often when litigation picks up.  But the real issue has to do with a lack of clarity in the text of royalty and lease documents.  And this issue boils down to the valuation point, the physical location where the commodity or products are measured.

Challenge:   The Courts have produced a hodgepodge of rulings that tend to be specific to individual cases.  Cash is king, so if you can get to the actual, observable movements of cash through the value chain, then the value can be allocated properly.  It would be even better if lease and royalty documents were drafted more carefully!

Solution:  Map and model the actual cash flows penny by penny the same way that supply chain professionals map and model each step.  Oil and gas production is a supply chain that ends up in a place where the commodity is changed into something that is useful, like fuel, rubber, or natural gas that is dry and safe to burn in a power plant.  And let us keep our eyes on a critical case before the Texas Supreme Court – BlueStone v. Randle.

Royalties disputes and litigation are as old as royalties themselves, but they do ebb and flow with commodity prices.  Higher prices tend to mean that royalty owners are happy, and often do not scrub their royalty statements carefully.  Lower prices lead to a closer look, and that’s when the arguments begin.

What continues to be contentious here in Texas involves the text of how royalties are calculated and paid.[1]

  • What are the gross profits?
  • What is the market “at the well” valuation?
  • What are the production costs?
  • What does it mean to make oil or natural gas “marketable”?

It is true that oil and gas production involves complexities that other businesses do not have, and the gathering, processing, transportation, and marketing processes and costs can be opaque.  However, as a former treasury professional with two Fortune 100 energy companies, I can articulate that cash does not lie.  If the royalty and lease agreements are written better, to be very clear about how each and every movement of cash is calculated and accounted for, then there will be fewer disputes.

There are many royalty dispute cases in Texas every year, and this state’s Supreme Court has produced a body of rulings that are usually very linked to the exact language of specific royalty and lease documents.  Rather than go through this body of work, dating back to Heritage Res., Inc. v. NationsBank, 939 S.W.2d 118, 120-21 (Tex. 1996), I’d like to probe a case that is quite fresh: BlueStone Natural Resources II, LLC v. Walker Murray Randle, No. 19-0459.

BlueStone Natural Resources II, LLC v. Walker Murray Randle, No. 19-0459

The Texas Supreme Court agreed to hear this case on September 17th, 2020.  It is a very important case because it touches on two critical issues.  First, there is language in the leases, that was added in an addendum, that attempts to change the term on the original document from “market value at the well” to “gross value received.”  The second issue, which will be more and more critical as electric frac continues to grow, has to do with whether or not production from a well that is used as a fuel can be deemed “operations which Lessee may conduct hereunder.”  Electric frac means that the big engines used to force fluids into the ground (hydraulic fracturing), are gas-fired engines, and not the more common diesel engines.  Electric frac is growing because it is both more efficient, thereby cheaper, and better for the environment.

It will not just be Texans watching this case; various states around the nation that have oil and gas production in meaningful levels will also be watching.  This includes Ohio, Pennsylvania, Oklahoma, New Mexico, Louisiana, Colorado, and others.  It might be time to answer some key questions!

  1. Are “gross value received” and “gross proceeds” the same exact thing?
  2. If not, why not?
  3. Do either or both determine the actual valuation point for a sale?
  4. Is this the same as valuation point at a well?
  5. If not, why not?
  6. Are they observable, economically viable valuation methods?
  7. What is the difference between a valuation point at a well and a valuation point at the moment of a sale?
  8. How does title transfer of a raw commodity, an intermediate product, and/or a finished product; play into this debate?
  9. How can we draft these documents more clearly so as to avoid disputes, particularly when commodity prices are low? (I know, the Supreme Court is not going to give us the answer to this question!)

This case is a very significant case.  The oral arguments made last September really pointed out how so many previous decisions on these topics conflict and/or leave open significant issues.  We await with bated breath for a decision from the Court, and we shall see if the decision makes things clearer or continues to kick the can down the road.

Essential Valuation Factors

ValueScope assists clients by providing independent, third-party valuations that are generally triggered by an event, such as a sale, a buy, estate planning, tax work, GAAP application, bankruptcy, and litigation.  A short cheat sheet of the key valuation items we use to assess oil and gas royalties are summarized right here:

  • The Valuation Date or Dates
    • Get this clearly established at the outset.
  • The Purpose of the Valuation
    • What exactly is it for? Who will be reading it?  This will determine the Standard of Value; there are more than one.
  • The Standard of Value
    • “Fair market value,” is mostly used for tax purposes, but it is really the primary and most customary Standard in the USA. “Fair Value” is the US GAAP application standard.  Private capital firms use “Investment Value,” and a large part of this will usually involve exit assumptions.  “Intrinsic Value” is what equity research analysts use when they look at public stocks and bonds.  “Liquidation Value” is used for distressed situations and can be forced or orderly.  “Strategic value” is what you will see when big companies merge together, like when Shell acquired British Gas.  The large premium paid is based on a very long range, and quite permanent, model of the combined companies.  Using the proper standard of value is crucial to obtain an accurate determination of value and is necessary to avoid miscommunication in scoping the work upfront.
  • The Levels (Premise) of Value
    • Controlling interest basis means the value of the enterprise as a whole. It incorporates two components, the financial control level, and the strategic control level.
    • Marketable minority interest basis refers to the value of a minority interest, without control. It does, however, have liquidity as if it were freely tradable in an active market.  The marketable minority level of value is also valued on an enterprise-level of value, meaning that it is modeled on 100% of the expected cash flows of the enterprise.
    • Non-marketable minority interest basis means the value of a minority interest, that has neither control nor market liquidity.
    • Here is the point for this article-royalty interest owners do not own an interest in a business, so we view their interest to be either a marketable or non-marketable minority ownership interest in a business. This is often contentious because lots of royalty owners do not understand why their valuation must be subjected to discounting.  They do not control the drilling activity of the operator, and they have no voice in strategic direction or management decisions.  Plus, royalty interests are not marketable the way that shares in a publicly-traded company can be bought and sold easily.  If you want a valuation that has no minority discounting, then buy the entire company!
  • Important Industry Factors
    • There are no standardized rules for the valuation of oil and gas assets. The value of mineral and royalty interests is based on expected future cash flows generated by leasing and/or production, and this is driven by oil and gas market prices.  It is a price-taker business.
  • ValueScope considers and models a wide range of issues when we deliver this type of work:
    • Commodity Price Volatility
    • Technology
    • Basins/Access to Markets
    • Regulation
      • Treasury Regulations Section 1.611 – “the fair market value of an oil and gas property is the amount which would induce a willing seller to sell and a willing buyer to purchase.” Additionally, Section 1.611-2(g) outlines some considerations that a valuation of mineral properties must include for tax-oriented appraisals.
    • Well Economics
    • Financial & Strategic Condition of Operator
    • Working Capital
    • Leverage
    • Capital Budgeting and Drilling Plans
    • Break-even Analysis
    • Post-production deductions
    • The Asset-Based Approach
      • This approach is not useful for determining the value of royalty interest, and we do not use it. Usually, a royalty owner purchased land which included the mineral rights and an allocation of surface versus mineral rights was never done.  In other words, it can be hard to tell the cost basis of the assets, compounded by the fact that royalty interests are often family assets that are handed down for generations.  Captain King and his partner Gideon “Legs” Lewis bought a 15,500-acre Mexican land grant called the Rincon de Santa Gertrudis, and this started the King Ranch of Texas.  They paid $300; we cannot use that factoid in any meaningful way today for valuation purposes!
    • The Market Approach
      • The market approach uses comps, both trading and transaction. ValueScope uses direct comparable transactions of royalty interests if they are available.  However, they usually are not available, so the market-based approach is often not useful.
    • The Income Approach
      • ValueScope generally uses this method, by building a discounted cash flow analysis. We are experts with PHDWin software, and this allows us to customize the economics of the facts of the actual wells and the deal, making it a bespoke valuation.  We project production levels over the well portfolio’s useful life.  Revenue is based on both production and price; as such, we prefer to use simulation models to value over a range of oil, gas, and NGL prices.  Cash flows net of severance, ad valorem taxes, and other deductions is then discounted back to present value using a discount rate that is meaningful.  In other words, the traditional “PV10” number using 10% is not useful; it is too low.


BlueStone v. Randle is a big deal, and we shall see what it produces.  In the meantime, it is always best to find professionals who understand all the issues embedded on oil and gas royalties, including recent case history.  This is the only way to get this kind of valuation done properly.

ValueScope: Measuring, Defending, and Creating Value for Our Clients

ValueScope is a leader in the application of fair value measurement applying the Mandatory Performance Framework for better compliance with the Public Company Accounting Oversight Board.

For more information or to contact us for any need you may have, please feel free to write or call.  We look forward to speaking with you.



Tom McNulty, CQF, FRM, MBA



The information presented here is not nor should it be treated as investment, financial, or tax advice and is not intended to be used to make investment decisions.

If you liked this blog you may enjoy reading some of our other blogs here.

Tax Benefits of the CARES Act to Energy Companies

Click to Download:  Tax Benefits of the CARES Act to Energy Companies

Executive Summary

Issue:  As the end of 2020 draws near, the benefits to energy companies of The Coronavirus Aid, Relief, and Economic Security (CARES) Act should be kept in mind for 2020 tax filings.  The CARES Act was signed into law on March 27, 2020, and includes broad measures to provide assistance, economic stimulus, and relief to American companies and individuals.  Certain measures included in the act are of significance to energy companies, particularly oil and gas upstream exploration and production companies which have faced difficulties in 2020 due to the drop in demand and commodity prices created by the COVID-19 pandemic.  Other energy companies such as renewable energy-focused companies may also find benefits as well.

Solution:  Key measures in the CARES Act that should be considered include the reinstatement of net operating loss (NOL) carrybacks, more lenient guidelines for the business interest deduction, and the treatment of intangible drilling costs. Valuation and analytical work in this industry need to be done by firms that have the requisite experience and technical ability, as well as a strong understanding of the industry specifics and value drivers. Generalists will make mistakes you cannot afford.

On March 27, 2020, President Trump signed into law the Coronavirus Aid, Relief, and Economic Security (CARES) Act which included a broad number of measures aimed at providing relief and economic stimulus to the United States economy in response to the onset of a global pandemic caused by the COVID 19 virus. Many oil and gas exploration and production companies had already been facing difficulties before the pandemic due to a price war between Saudi Arabia and Russia, leading to lower commodity prices. Certain measures of the CARES act could provide some real short-term benefit and liquidity to oil and gas companies as well as to other companies across the broader energy space. Below is a summary of some of the CARES Act provisions which could be of use to energy companies.

NOL Carrybacks

One of the most significant changes to tax law from the CARES Act is the reinstatement of the net operating loss (NOL) carryback provisions under IRC section 172 and the lifting of the 80% limitation on NOLs for future periods. The ability to apply NOLs to prior periods was removed with the passing of the Tax Cuts and Jobs Act (TCJA) in 2017, and it also limited application for future periods to only 80% of the operating loss. The new CARES act allows companies to carry back NOLs incurred in tax years 2018-2020 for up to five years, offsetting 100% of taxable income in those periods. Of particular advantage for oil and gas companies is the ability to apply NOLs incurred during periods of low commodity prices to those of higher commodity price environments, including periods where the prior 35% tax rate was applicable.

Sources of NOLs could be current year operating losses given lower commodity prices, as well as asset impairments for long-lived assets such as plant and equipment and oil and gas reserves, particularly those with shorter expected lives.  An oil and gas company with marginally profitable reserves in recent periods could support impairing those assets in the current environment, thus creating or increasing an NOL for the current year.  Additionally, oil and gas companies could review oil and gas leases, and impair the value and costs associated with any abandoned or expired leases. Lastly, the TCJA also increased the bonus depreciation percentage to 100% for qualified property acquired and placed between September 27, 2017 and January 1, 2023. As such, it might be possible and advantageous for oil and gas companies to utilize bonus depreciation in the current tax year in order to create NOLs to carry back, however the decision should also consider Management’s business outlook and as a consequence its assessment of the value of such depreciation in future years.  Receiving cash in the form of significant refund checks made possible by NOL carrybacks would be welcomed by a company seeking additional liquidity currently amid lower demand and commodity prices stemming from the COVID pandemic.

For renewable energy companies, accelerated Modified Accelerated Cost Recovery System (MACRS) depreciation could have additional value as facilities which came online in 2018 or 2019 could elect to apply NOLs stemming from the significant depreciation deductions associated within the first two years of the 5-year MACRS schedule to earlier periods when the 35% tax rate was in place. As mentioned above for oil and gas companies, renewable companies may also find value in utilizing bonus depreciation aside from accelerated depreciation for the purposes of utilizing NOLs.  For certain tax equity structures, these depreciation elections could increase the internal rate of return of the tax equity investment, resulting in earlier flip periods and higher overall cash investment returns than originally expected.

Business Interest Deduction Changes and Intangible Drilling Costs

In addition to operating losses stemming from lower commodity prices, oil and gas companies can also take advantage of changes in the deductibility of business interest costs. Another provision of the CARES Act was the change in the limitation of interest deductibility from 30% of adjusted taxable income to now 50%, however the change is only applicable to the 2020 tax year. As a result, certain energy companies with significant leverage may be able to better utilize interest costs as deductions and operating losses this tax year.

Oil and gas companies can also potentially create or increase operating losses by deducting intangible drilling costs (often in the form of wages, fuel, and supplies) which may be deducted or capitalized for tax purposes. If deducting the intangible drilling costs would not result in an operating loss that could be carried back and utilized to create refunds, companies should consider capitalizing the costs and deducting over a 5-year period, creating positive value as a deduction in a hopefully higher earnings environment.

ValueScope Can Assist You

Overall, the CARES Act includes several benefits to energy companies. ValueScope can assist your company in its tax and financial reporting requirements, especially when valuation and cash flow forecasting are at play, such as in the asset impairment process. ValueScope’s energy team provides services to clients operating across the entire energy industry, from oil and gas producers to renewable energy generators. Our expertise is deep and broad, which allows us to offer specific technical and industry insights and capabilities that cannot be matched by generalist firms. We have a rare combination of industry, banking, consulting, valuation, and government experience at ValueScope.  We understand all of the factors and drivers that move energy markets today.

For more information, contact:

Brad R. Currey, CEIV, CFA

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The information presented here is not nor should it be treated as investment, financial, or tax advice and is not intended to be used to make investment decisions.

If you liked this blog you may enjoy reading some of our other blogs here.

Middle Market Private Equity M&A Activity – Q2 2020

Click to Download:  Middle Market Private Equity M&A Activity – Q2 2020

Executive Summary

Transaction Volume Shrinks

Only 31 transactions were reported in Q2 2020, bringing the total reported transactions in 2020 to 113.

Size Premium

Size became an even greater pricing consideration for the middle market as transaction multiple variances widened for acquisition targets above and below $50 million.

Debt Usage Decline

In Q2 2020, total debt to EBITDA fell to 3.3x from 3.9x the prior quarter. This 0.6x decline in total debt to EBITDA was attributed to a decline in senior debt to EBITDA, pushing the percentage of subordinate debt to total debt to 15.2%, up 2.4% from the previous quarter.

Media & Telecom Soars

In the first two quarters of 2020, transaction multiples for the media & telecom industry rose almost 30% to its highest level over the past five years. This was accompanied with substantial increases of transaction multiples in the distribution and manufacturing industries.

Based on our review of GF Data’s latest M&A Report, the reported results for Q2 2020 display a sizable decrease in completed deals, having about 40% of the completed deal volume compared with Q1 2020 and Q2 2019. As the first quarter fully submerged in the COVID-19 pandemic, Q2 2020’s results reveal interesting consequences. Despite the simple average enterprise value (EV) to EBITDA multiple remaining at 7.4x from Q1 2020, total debt dropped to 3.3x, down from the 3.7x – 4.0x range over the previous several of years. The percentage of subordinate (sub) debt to total debt averaged only 14.0% in 2020. This is down from the 2019 average of 19%.

Middle Market Private Equity M&Amp;A Activity - Q2 2020

In the first quarter of 2020, average EV/EBITDA transaction multiples increased for the larger companies in the $50 – 250 million enterprise value range and decreased for the smaller companies in the $10 – 50 million range. The increased market uncertainty likely caused a premium to be paid for the larger, and perceived safer, companies. Both smaller and larger companies’ multiples slightly increased in Q2 2020, maintaining the considerable spread in multiples between smaller and larger companies.

Middle Market Private Equity M&Amp;A Activity - Q2 2020

Industry Analysis

We analyzed industry average EV/EBITDA multiples of acquisition targets to gain a more in-depth understanding of how the market perceived industry risk and growth prospects as COVID-19 disrupted the marketplace during the second quarter. Approximately 80% of the reported deal volume comprises four industries: manufacturing, business services, health services, and distribution.

Middle Market Private Equity M&Amp;A Activity - Q2 2020

The average EV/EBITDA transaction multiple for health care services steeply declined to 7.0x in 2020 from 8.4x in 2019. The health care services industry has been negatively impacted in the short-run by the COVID-19 pandemic, as both practices and patients avoided preventative check-ups and elective treatments. To the contrary, the distribution industry average EV/EBITDA multiple increased to 8.5x, up from 7.0x in 2019. The distribution industry was valued extremely high in Q1 and Q2 2020 as consumer e-commerce presence and demand for deliver-to-door goods grew considerably. The manufacturing industry also increased to its highest average EV / EBITDA multiple over the past five years, up to 7.2x. The technology industry experienced a dip in its average EV/EBITDA valuation multiple to its lowest level since 2016. The retail industry average EV / EBITDA multiple was down from its 2019 high of 9.3x yet remained significantly higher at 8.9x than its 2018 average of 7.5x. The Media & Telecom industry average EV / EBITDA multiple soared to 9.0x in 2020 from its 2019 average of 7.0x. America’s dependence on robust internet connection and digital media and entertainment became even greater as much of the country began working from home and spending more leisure time at home in 2020. Business services industry average EV / EBITDA multiple remained approximately the same over the last five years.

For more information, contact:

Middle Market Private Equity M&Amp;A Activity - Q2 2020

Michael Hanan

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The information presented here is not nor should it be treated as investment, financial, or tax advice and is not intended to be used to make investment decisions.

If you liked this blog you may enjoy reading some of our other blogs here.

How to Avoid Chapter 22 in Restructuring Work for Energy Companies

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Executive Summary


It takes time and money to go through a Chapter 11 restructuring, so going through it twice in a couple of years is unwise and inefficient.  Recently, it has been an issue with companies operating in the energy complex.  The challenges and complexities of energy markets make reorganization plans hard to properly formulate.


The challenge for counsel and financial advisors has to with the often-severe price volatility common to oil and gas markets.  Restructuring practitioners are usually generalists, and often do not understand commodity markets or their impact on cash flow and debt capacity well enough to make plans feasible.


Generalists will make mistakes.  The solution calls for advisors who have deep and broad energy complex expertise.  Regardless of “customary” practices, using simple deterministic models is a poor idea.  The cash flow analysis that is done to support the feasibility of a plan of reorganization should not be deterministic.  Rather, it should be probabilistic, or stochastic.  Decisionmakers, including the courts, should be provided with a stress-tested model.

“Chapter 22” is not a technical legal term.  And it is not really a new term.  In fact, there was a roundtable at the Harvard Law School in 20141 that focused on this very thing.  Chapter 22 refers to a situation in which a company that had gone through a Chapter 11 filing, and emerged, has gone back into Chapter 11 again in short order.  What are the causes?  The Harvard Law School panel featured some of the nation’s finest bankruptcy attorneys.  Harvey Miller, of Weil, Gotshal & Manges, said that increased “recidivism” in Chapter 11 filings was mainly due to distressed debt and securities investors, who effectively gained control of the debtor and its plan formulation process.  This means they do all that they can to get the plan of reorganization confirmed.  Sometimes the plan’s actually feasibility is not well scrubbed.2 Marshall Huebner, of Davis Polk & Wardwell LLP, pointed to other factors that can cause a subsequent Chapter 11 filing, such as the underestimation of an industry’s more permanent decline, or creditor pressure on the debtor to keep too much debt.3  Mark Roe, a professor at Harvard Law School, articulated that Chapter 22 filings are not that common, and represent less than 20% of Chapter 11 debtors.  He also suggested that it might not be a poor trade-off, if most of the firms that file again do well.4  We are not as sanguine.  Why not do it right once?  And for companies that operate in the Energy Complex, doing it right the first time means you need to pay attention to the fundamental drivers of commodity price volatility.

What Does the Law Say?

In looking in the U.S. Bankruptcy Code, Section 1129(a)(11) provides, “The court shall confirm a plan only if all of the following requirements are met: Confirmation of the plan is not likely to be followed by the liquidation, or the need for further financial reorganization, of the debtor or any successor to the debtor under the plan, unless such liquidation or reorganization is proposed in the plan.”5  So how does Chapter 22 happen?  In the context of energy companies, it happens when the debt load post-restructuring is based on wishful thinking as to how oil and natural gas prices will behave in the months and years after emergence.  Very few workout practitioners run detailed analysis of pricing trends and the actual debt capacity of the restructured firm if and when commodity prices fall.

Why is Energy Different?

Commodities, including oil and gas, are far more volatile than other asset classes like fixed-income and equities.  We have discussed this in a separate article recently published on our site.6  WTI oil has an average annual volatility of more than 40%, and the NYMEX Henry Hub natural gas contract is even higher.

This chart, below, was prepared by the Texas law firm Haynes Boone,7 which has been doing outstanding work in recent years tracking oil patch bankruptcies.  Note that Ultra Petroleum is listed.  Ultra Petroleum filed for bankruptcy back in May of 2016, so this is its second filing in four years.  It came out of Chapter 11 in 2017 with nearly $3 billion in new debt.  We wonder what natural gas price assumptions were used at that time when the plan was approved.  Energy commodities usually do not follow lognormal random walks and should be modeled via simulation.  The processes they follow have similarities to ARMA–GARCH models. The reason for this is that oil and gas prices move with the volatility of their physical and financial markets, as well as complex density functions of future prices that incorporate price jumps or “shocks.”8

How To Avoid Chapter 22 In Restructuring Work For Energy Companies

Simulation Models

Attorneys, and judges, often call simulation models “speculative.”  Given the anniversary that just happened, of the atomic bombings of Hiroshima and Nagasaki, it is well worth noting that Monte Carlo Simulation was used at Los Alamos, New Mexico as part of the Manhattan Project.  Arguably, its modern form using randomness with discipline and rigor, in computational analysis, was developed there.  There was no other way for the experts at Los Alamos to estimate how far a neutron will go before it hits something that will cause energy to be released.  There is nothing speculative about this technique.  It was a tested mathematical process used then, to model fast neutron chain reactions.  And it is especially common now in the energy, economics, physics, and pharmaceutical professions.

The term “stochastic” has its roots in the Greek word στόχος, which can be “stókhos” or “stóchastikos” in English.9 One definition of the word is “to guess,” which is why some lawyers think it is speculative. However, it also means “to aim or target.”  This is how we use it in finance, economics, etc.  The modeling that is done as part of any restructuring process, and reorganization plan, should consider more sophisticated approaches.  In our view, practitioners need to:

  • Take the 13 week rolling cash flow model used during the workout process and expand it to five years.
  • Use sensible input assumptions, especially with distributions and probabilities that are based on reality.
  • Run commodity prices that consider mean reversion and actual volatility assumptions, not wishful thinking
  • Stress test the forward-looking cash flows and debt capacity; and make them as sober as possible.

The cash flows we isolate are tested for their ability to support debt, the new capital structure of the restructured firm.  The critical inputs, especially commodity prices, can be matched to levels of debt that can be supported given the range of potential outcomes.  This type of modelling allows for price jumps or shocks to be tested carefully as well.  It is important to note that we do not use this technique to reach one specific answer.  Probabilistic modelling provides real decision makers with a range in which they can negotiate and design a better capital structure for the most likely economic forecast.


There is no reason for any energy company to go through a “Chapter 22” process.  The tools, techniques, experience, and data are all available such that any plan of reorganization can be constructed to model risk adjusted cash flows.  Lawyers, the Courts, and financial participants will develop more comfort with simulation techniques the more they are used by advisory practitioners.  The results for the various stakeholders will be far improved.

ValueScope: Measuring, Defending and Creating Value for Our Clients

ValueScope is a leader in the application of fair value measurement applying the Mandatory Performance Framework for better compliance with the Public Company Accounting Oversight Board.

How To Avoid Chapter 22 In Restructuring Work For Energy Companies


[1], Stephanie Massman (J.D. 2015).

[2] Ibid.

[3] Ibid.

[4] Ibid.

[5] 11 U.S.C. §1129(a)(11)

[6] “ESG-A Valuation Framework”


[8] “Oil prices — Brownian motion or mean reversion? A study using a one year ahead density forecast criterion,” Nigel Meade, Energy Economics, Energy Economics, Volume 32, Issue 6, November 2010, Pages 1485-1498.


For more information, contact:

Thomas J. McNulty CQF, FRM, MBA


The information presented here is not nor should it be treated as investment, financial, or tax advice and is not intended to be used to make investment decisions.

If you liked this blog you may enjoy reading some of our other blogs here.

Oil and Natural Gas Prices-Are They Sustainable at These Levels?

Click to Download:  Oil and Natural Gas Prices-Are They Sustainable at These Levels?

Executive Summary


There are three primary drivers that must be considered when looking at oil and gas prices.  First, they are commodities, and move with the complex economics of global supply and demand.  Second, they are very volatile.  And third, they can be significantly influenced by global, geopolitical factors.


The challenge for anyone doing transaction, valuation, bankruptcy, and litigation work with companies whose cash flows are driven by oil and gas prices is that the analysis can be very hard to do.  Often short-cuts are taken, such as using flat price curves or minimal sensitivity analysis.  These simplifications can be disastrous.


The solution involves having a deep understanding of commodity market behavior and pricing as a prerequisite to engaging in any professional services exercise with energy companies.  Analytical work in this industry needs to be done by those firms that have this experience and technical ability, with an eye toward rational, not aspirational, commodity pricing as the basis of work product.

I can remember it like it was just yesterday.  We were doing modeling and valuation work for an independent, upstream E&P (exploration and production) company.  The valuation element was for equity compensation, for Accounting Standards Codification “ASC” 718 and Internal Revenue Code “IRC” 409(a) purposes.  The broader modeling aspect was treasury focused, to stress test the debt capacity of the business.  The front month West Texas Intermediate (“WTI”) contract was trading at about $105 per barrel, and we wanted to risk our cash flow model.  The Client said something to the effect “OK, go ahead and run an $85 oil case if it makes you happy.”  We all know how the story ends, a couple of years later.  WTI closed at $26.19 on February 11, 2016.

Natural Gas is no stranger to rapid price movements either, as anyone working in this part of the country knows.  Whenever there is a hurricane in the Gulf of Mexico, prices spike rapidly over assumptions that production will be cut because of the storm, lowering supply.

But we might be asking the wrong question with “Oil and Natural Gas Prices-Are They Sustainable at These Levels?” The answer is “yes,” as this short article will discuss.  But the real question should be “which price level assumptions for oil and gas should be used for valuation, lending, transaction, and capital investing decisions?”  We are probably right at those very levels now.  Hope is not a strategy, and it is essential for all of the various players in the oil and gas business to avoid the notion that we can expect prices to “go back up” or “be where we need them to be” or “return to normal.”  Oil and gas prices are trading where they should be trading, given market dynamics, so plan accordingly.

Supply and Demand

Crude oil is supplied and consumed globally. The U.S. Energy Information Administration (“EIA”) is an excellent source for data on a wide variety of economic information and analysis, including supply and demand, across the energy complex.  It is part of the U.S. Department of Energy (“DOE”).  For example, the most recent EIA newsletter highlights that “annual U.S. crude oil production will average 11.6 million b/d in 2020, down 0.6 million b/d from 2019 as result of a drop in drilling activity and production curtailments related to low oil prices.”1 This is a textbook supply/demand sentence.  Lower prices caused some producers to cut back, and this in turn lowered supply.  There is broad consensus that the COVID pandemic has pressed global oil demand downwards, and there is plenty of data that supports this thesis.  The EIA analysis also includes references to COVID.

The supply side is an important factor as well.  On March 9 of this year, oil prices dropped when Saudi Arabia boosted its oil production to challenge Russia for its failure to adhere to production quotas.  The Organization of the Petroleum Exporting Countries, OPEC, manages crude oil supplies via a quota system.  OPEC+ refers to a broader group of producing nations formed about three years ago.  Russia is the dominant non-OPEC player in OPEC+.  It is not a mystery where crude oil supply comes from, the challenge has to do with how quickly demand will return to levels seen before COVID.

Natural gas was traditionally not supplied and consumed globally.  It is typically shipped via pipelines, and this is hard to do (and too expensive) across the world’s oceans.  The Liquefied Natural Gas (“LNG”) industry developed to solve this challenge.  LNG is natural gas, or methane, usually with some ethane in it, that has been cooled to -260 degrees Fahrenheit.  Why?  Because at this temperature natural gas can be transported quite safely, because it does not have to be pressurized at this temperature.  It is not flammable or explosive in this state.  LNG can be moved in large ships to where it is needed, and then re-gasified to be burned as fuel.

LNG can solve a fundamental market supply-demand problem:  there is a lot of gas in places where it is not necessarily needed, and not enough gas in places that could use it for power generation instead of coal.  According to the EIA “the Henry Hub natural gas spot price averaged $1.63 per million British thermal units (MMBtu) in June.”2, due to low demand.  The so-called shale revolution here in the U.S. opened vast reserves of natural gas, and natural gas liquids, that exceed the demand needs here in the U.S.  Potential demand from abroad is real, if and only if the US can ensure that it will produce the gas and get it to Asia and to Europe.

Petroleum economics is a big, complex topic, and beyond the scope of this short article.  The key takeaways on the supply side are that the OPEC+ group of powers will continue to try to manage oil prices by controlling supply, offset to some degree by the rapid growth of production potential in the U.S.  Look at it as a rough, imprecise cap and floor structure.  If OPEC+ reduces supply, to drive up prices, more U.S. production will enter the market, thereby placing downward pressure on prices.  It’s not exact or clean, given that different grades of crude oil and refinery capacity play a role in the dynamic as well, but the broad theme is correct and should keep us in the trading range we are in now for the near-term.

As for natural gas, there is no shortage on the supply side.  This question remains: will gas-fired power generation in both the developing and developed world replace coal rapidly, such that demand pushes prices up?  Until Washington, Oregon, and California become more concerned about the climate, and allow the U.S. to send LNG directly to Asia through the West Coast, where it will replace and eliminate coal power plants, the outlook is flat for now.


Commodities, including oil and gas, are far more volatile than other asset classes like fixed-income and equities.  Using data from the EIA, I have illustrated below just how volatile they can be.  The EIA data for WTI Spot, at Cushing Oklahoma, goes back to January 15, 1986.  From then until now, the average annual price volatility has been 44%, and this does not include the aberration in prices that happened this year when WTI closed below zero.  That episode highlighted the impact that financial trading can have on a physical market.  Note that the mean price during this period is $44, and the median is about $31.  Given that oil prices are a large driver of inflation, especially Producer Price Inflation, it is unwise to inflate oil or gas prices.  This is a form of double-counting and is also true of most other commodities.

This EIA data supports the contention that prices are sustainable where they are now.  Why do market participants talk about prices “recovering?” Recovering to what price level?  There is a good deal of evidence that suggests commodities are mean reverting, at least to some degree. If this is the case, then perhaps oil is reverting to its mean right now.

Oil And Natural Gas Prices-Are They Sustainable At These Levels?

Natural gas volatility has been even worse, although less so lately.  From January 20, 1997, to now, the Henry Hub contract has experienced very high annual volatility.  At this time, we are well below both the mean and median prices, and this is a direct result of the supply side.  Natural gas is being flared now in the U.S., which means that it is being burned at the well head rather than gathered and transported to markets.  The demand side of the supply-demand dynamic is insufficient, so gas is being wasted.

Oil And Natural Gas Prices-Are They Sustainable At These Levels?

Given this kind of severe volatility, for both oil and gas prices, it is inherently dangerous for market participants and their advisors to do valuation, lending, and deal work based on potential price upside scenarios.  The supply-demand balance in place now, coupled with price levels at or below long-term averages, supports the notion that current price levels are sustainable.  These implied prices are based on lognormal analysis, given that oil prices do not consistently behave lognormally, some deviation can be expected.  However, think of it this way, it is  a much longer distance to travel from current prices up to $90, than it is back down to $16!

Oil And Natural Gas Prices-Are They Sustainable At These Levels?


Oil prices, far more so than gas prices, have been impacted by geopolitics for many years, as oil can be used as an economic weapon.  For example, in 1940 and in 1941, the U.S. took several actions that ultimately cut off Japan from the vast majority of its oil supply, to punish it for aggression in China and Southeast Asia.  In October of 1973, OPEC embargoed oil shipments to the U.S., as a direct result of President Nixon’s support for the State of Israel during the “Yom Kippur” or “October War.”  However, diversity of supply can mitigate oil being used as an economic weapon.  Earlier this year, when Iran fired missiles at American forces in Iraq, oil prices jumped by about 4%.  But that is not the point of the story.  The fact that they only jumped 4% points to the impact that U.S. oil production has had in the market.  Price spikes in the past, due to heightened tensions in the Middle East and Persian Gulf, were always much higher.  Oil and gas prices are sustainable at current levels because there is more diversity of supply than there was in the past.


There is a standoff to some degree right now, within the supply and demand structure of oil and gas prices.  WTI is trading right above $40 per barrel, and natural gas is below $2.00 per MMBtu.  These price levels are sustainable because the supply-demand balance is capped and floored between OPEC+ and the vast potential of U.S. reserves and production.  Volatility continues to be very real, and high, but oil and gas prices, like most commodities, usually display some elements of mean reversion, and we are at or below long term mean prices.  And while geopolitical shocks still can and will move oil prices, supply diversity has reduced this traditional impact measurably.  The trading range we are in now for oil and gas prices is sustainable and can be expected to remain consistent through the rest of the year.

ValueScope: Measuring, Defending and Creating Value for Our Clients

ValueScope is a leader in the application of fair value measurement applying the Mandatory Performance Framework for better compliance with the Public Company Accounting Oversight Board.

Oil And Natural Gas Prices-Are They Sustainable At These Levels?


[1] US Energy Information Administration, Short-Term Energy Outlook, July 2020

[2] Ibid.

For more information, contact:

Thomas J. McNulty CQF, FRM, MBA


The information presented here is not nor should it be treated as investment, financial, or tax advice and is not intended to be used to make investment decisions.

If you liked this blog you may enjoy reading some of our other blogs here.