Valuation, Growth, and Appraisal Arbitrage
The appraisal remedy under US corporation law is intended to protect stockholders of target corporations who are forced to sell in a merger. But recently it has become common for appraisal arbitrageurs (hedge funds) to buy target shares to assert appraisal rights. Aside from whether the law should permit investors to buy into such claims, the puzzle is why it is profitable to do so. In other words, why do the courts so often award more than the agreed merger price in appraisal proceedings? Several explanations have been offered, but the most likely is that the valuation model typically used by the courts is mistaken in the way it addresses a firm’s long-term growth prospects. The mistake is that the model adjusts discount rates downward (and thus valuation upward) by economy-wide growth projections. A better approach would be to recognize that predictable growth in firm-specific returns comes only from plowback (reinvestment) of free cash flow. Although corporations can (and do) increase in value for other reasons, such growth in value is too speculative to be awarded under the appraisal remedy.