This is the second in a two-post series on a buy-sell agreement between giants and involving a substantial business enterprise.  The first post outlined the Definition of FMV, or presumably, fair market value of some sort, to determine price per the Amended and Restated Limited Liability Company Agreement of Morgan Stanley Smith Barney Holdings LLC (“MSSBH”) (“the LLC Agreement”) and dated May 31, 2009.

The Announcements

Morgan Stanley (MS) notified Citigroup Inc. (C) in a Form 8-K filed May 31, 2012 that it intended to exercise its option to acquire 14% of Morgan Stanley Smith Barney Holdings LLC (MSSB) of the 49% of the joint venture (JV) owned by Citigroup.

Citigroup Inc. (C) announced in a Form 8-K on July 16, 2012 that Morgan Stanley (MS) had exercised its option to acquire, over time, its 49% stake in Morgan Stanley Smith Barney Holdings LLC.

Morgan Stanley filed a Form 8-K on September 11, 2012 announcing the consummation of the buy-sell agreement process outlined in the previous post about this deal.

Citigroup filed a Form 8-K on September 11, 2012 announcing the consummation of the buy-sell agreement transaction.

The financial press announced the resolution of the pricing of the purchase in articles on September 11, 2012 (at least here and here).

These announcements describe the operation of a buy-sell agreement involving the highest market capitalization company I have yet seen in operation  and provides a fascinating glimpse into Wall Street.

Buy-sell agreements come in all shapes and sizes and, perhaps, colors, too.  I’ve held off writing about this one until it was resolved.

A Buy-Sell Agreement Gone Public

Let’s summarize a number of facts that are now known about the buy-sell agreement between Morgan Stanley and Citigroup regarding a 14% common member interest of the 49% common member interest owned by Citigroup since the formation of MSSBH in May 2009.

• Morgan Stanley exercised its option (Call Right) to purchase the 14% interest noted above effective June 1, 2012.
• Morgan Stanley hired Morgan Stanley Investment Banking (“MSIB”), its investment banking arm, to be its Appraiser (per the LLC Agreement) and to perform its initial estimate of FMV (as defined in the prior post).  Morgan Stanley Investment Banking concluded that its estimate of FMV was $9.0 billion.
• Citigroup filed a Form 8-K on July 16, 2012 and announced several things.  Its Appraiser was Citigroup Global Markets, Inc. (“CGMI”), and CGMI concluded that its estimate of FMV was $22.5 billion.  Citigroup also announced that its carrying value for its 49% interest in MSSBH was about $11 billion, implying an enterprise value of $22.5 billion, which was the approximate conclusion of CGMI.  The Citigroup announcement went on to suggest that, depending on how the appraisal process turned out, a writedown of its carrying value might be necessary.
• In accordance with the valuation process outlined in the LLC Agreement (and discussed at length in the prior post on this topic), MSIB and CGMI agreed on the selection of Perella Weinberg Partners as the third Appraiser called for therein.
• Perella Weinberg Partners (“PWP”) was described in the business press as having “wide latitude” in arriving at its determination of FMV.  The reason that the third Appraiser had such wide latitude is that their interpretation of the “words on the pages” of the LLC Agreement was going to be binding.
• PWP concluded that FMV was $13.5 billion (enterprise value), which was the conclusive pricing for Morgan Stanley’s purchase of the 14% common member interests owned by Citigroup (of its total of 49%). The price for the interest was $1.89 billion.
• Some $5 billion of deposits were transferred from Citigroup to Morgan Stanley for no consideration (i.e., no deposit premium).  That is the entire discussion in both companies’ Form 8-Ks, so I won’t speculate about what that meant.
• Interestingly, Citigroup agreed to sell its remaining 35% of MSSBH to Morgan Stanley between now and June 1, 2015 at the same enterprise value of $13.5 billion.  That is interesting and one could ask, why would Citigroup agree to such pricing?  There are several possible explanations, all of which are not necessarily consistent: (1) Citigroup is more bearish on the prospects of MSSBH than Morgan Stanley and wanted to lock in the price. (2) Citigroup was embarrassed by the public valuation process and the large implied write-down on its investment in MSSBH and wanted to avoid such a public process in the future. (3) Regardless of embarrassment, Citigroup simply wanted to get this situation behind them as soon as possible.

Interesting Insights

Let’s do a bit of math:

• The difference between the appraisals offered by Citigroup and Morgan Stanley was $13.5 billion, or, by chance, about the same as the conclusion of fair market value.  Perhaps that is irrelevant but it is nevertheless astounding.
• The 14% interest being acquired by Morgan Stanley has a value of $1.9 billion.
• At this $13.5 billion enterprise valuation, Citigroup’s 49% interest has a value of $6.6 billion, which is some $4.4 billion below its carrying value of $11 billion.  This suggests that there has been or will likely be a substantial impairment charge.

The agreement calls for Morgan Stanley to acquire the remaining 35% interest held by Citigroup by June 1, 2015 at the same $13.5 billion valuation.  Citigroup’s CEO Vikram Pandit had this to say:

I am pleased we have reached agreement on a value for our remaining stake in Morgan Stanley Smith Barney. Establishing certainty regarding the divestiture of this business is in the best interests of our shareholders

Morgan Stanley’s CEO, James Gorman had this to say:

This mutually beneficial agreement gives both parties certainty and transparency on price and timing, and is a significant milestone for Morgan Stanley in the implementation of our strategy.

These quotations are consistent with my interpretations above, or so it seems.

The LLC Agreement contained provisions found in many buy-sell agreements and provided a valuation process.  The process had a great deal of uncertainty, including uncertainty regarding where its conclusion would land, whether in the middle third (where its conclusion was binding on the parties), the lower third (where it would be averaged with the $9.0 billion conclusion of MSIB), or the upper third (where it would be averaged with the higher conclusion of CGMI.

It looks like PWP finessed the issue.  Let’s do a bit more math and see.

• MSIB’s conclusion was $9.0 billion, marking the lower bound for the valuation process (recall that PWP was required to agree with one of the two initial Appraisers, or to be within the range they established).
• CGMI’s conclusion was $22.5 billion (and all of these are close approximations), marking the higher bound.
• The difference between the first two estimates is $13.5 billion, so $4.5 billion is one-third of that.  The lower third is marked by the range of $9.0 billion to $13.5 billion, the middle third is from $13.5 billion to $18 billion, and the upper third is the range of $18 billion to $22.5 billion.
• With a conclusion at or very near the lower third boundary pricing of $13.5 billion, PWP appears to have agreed more with MSIB than with CGMI.  However, PWP was apparently not willing to drop below $13.5 billion, where its conclusion would then have been averaged with that of MGIB.  For example, of PWP had concluded that its estimate of FMV was $13 billion instead of $13.5 billion, the final result would have been $11 billion (the average of $9 billion and $13 billion).

All parties experienced substantial uncertainty with the buy-sell agreement process and the price wasn’t known until the end.  No one knew how the Appraisers would interpret the language in the LLC Agreement defining FMV, and no one knew who the third Appraiser would be until the selection of PWP was made.Until the actual appraisals become available publicly, it is not possible to know what caused the enormous $13.5 billion gap between the conclusions of Morgan Stanley and Citigroup.  One thing is certain.  Being large, even the sizes of Morgan Stanley and Citigroup, and being able to hire the largest law firms and the largest investment banking firms, does not avoid common problems with buy-sell agreements.

How Could the Result Have Been Different?

Had I been present when the LLC Agreement was being negotiated in May 2009, I would have suggested a single appraiser pricing mechanism like that outlined in my book Buy-Sell Agreements for Closely Held and Family Business Owners.  It is called the Single Appraiser, Select Now and Value Now valuation process.  The process would have gone something like this:

• The parties would have agreed on Mercer Capital (or another qualified, independent appraiser or investment banker, but I am writing this post!) to be the single appraiser for the valuation process and written this firm’s name into the LLC Agreement as the Appraiser when it was signed on May 31, 2009.
• The Appraiser would have provided an appraisal as of May 31, 2009 based on the agreed upon definition of FMV and it would have been discussed and reviewed by and accepted by Morgan Stanley and Citigroup.  This would have been much more likely at that time, since there was no Call Right that was exercisable for at least three years, and the interests of the parties were relatively aligned — else why would they have entered into the joint venture with MSSBH?
• The Appraiser would have provided an appraisal as of May 31, 2010 and May 31, 2011.  An appraisal would have been underway at the time Morgan Stanley exercised its Call Right on May 31, 2012, and its conclusion would have provided the pricing.
• The parties would have known who the Appraiser is, how the appraisal or determination of FMV would be conducted, what it should look like relative to prior appraisals based on changes at MSSBH, in the markets, the brokerage industry and the economy.  The determination of FMV as of May 31, 2012 would not have been embarrassing for Citigroup, since it would have kept its carrying value in line with the annual independent appraisal.  It would have provided certainty for all parties.

If you or a client have a buy-sell agreement with a multi-appraiser valuation process, it would be an excellent time to have your trusted advisers, including your business appraiser, review the agreement.  If results like we have just described above and in the last post can happen to Citigroup and to Morgan Stanley, they can certainly happen to you.

Help for Your Buy-Sell Agreement(s) is Available

For help, you can acquire a copy of Buy-Sell Agreements for Closely Held and Family Business Owners.  Quantity discounts are available.  Anyone buying the book now receives a complimentary copy of the companion piece, Buy-Sell Agreement Checklist, which provides a roadmap to discuss most valuation and business aspects of buy-sell agreements.