by David Lurvey, Timothy O’Brien, George J. Schultze
The current market environment has yielded a significant increase in both the number of entities considered to be distressed and the amount of money allocated to finding investment opportunities among distressed assets. In this market, investors looking for opportunities among distressed situations may find that standard valuation techniques alone are no longer as effective as they were in the past. Relative valuation metrics, market transaction multiples, and discounted cash flow (DCF) analysis must be modified to gauge the value of distressed enterprises accurately.
Distressed valuation analysis generally also requires a better understanding of the dynamics surrounding bankruptcy. Additional metrics that must be applied include a liquidation analysis, “normalized” cash flow projections, and the valuation of a company’s tax attributes. Experienced investors in the distressed arena who combine these techniques can make a far more informed decision about the outlook for investing long, or short, in the various securities of distressed entities.
Conventional relative valuation metrics alone don’t suffice in valuing distressed entities. Price-to-earnings, price-to-book value, and enterprise value-to-EBITDA (earnings before interest, taxes, depreciation and amortization, which serves as a proxy for cash flow) metrics do not work unless investors compare these ratios against a distressed peer group. Distressed entities generally have higher risk profiles and lower profitability levels compared to their healthy competitors, and a proper discount for distress, usually at least 20 percent, therefore must be built into the valuation.
In addition, alternative relative valuation multiples, such as enterprise value-to-sales and enterprise value-to-operating cash flow, may help. For example, in some distressed cases the target company may be undergoing so much change (rejecting leases, changing business lines, selling non-core assets, among other things) that focusing on historic EBITDA alone is less effective than the enterprise value-to-sales measure.
Investors nevertheless using EBITDA ratios should determine if all the appropriate one-time items and changes occurring in EBITDA have been adjusted for appropriately. Although alternative relative valuation methods are useful, they also reflect the idea that certain assumptions in the DCF model are either constant or unimportant altogether. Therefore, they generally should not be used without separate consideration for the factors that would go into a DCF analysis.
Even with adjustments, negative earnings or expected earnings may not be captured by the standard profitability measures used in the typical financial ratios or multiples applied to relative valuations. For example, housing sector EBITDAs often do not capture true operating cash flow due to capitalization of development costs, capitalization of financing, options on land, land banks, and other industry-specific factors. In these instances, investors are advised to use a measure of “normalized” cash flow, as discussed later in this article, as a helpful way to round out the picture of the subject company’s value.
Market Transaction Multiples
Market transaction multiples may help investors find good comparable companies’ valuation statistics for analysis purposes. Acquisition multiples implied by purchase prices in M&A transactions are good reference points, but investors must be sure to account for different business lines, risk profiles, profitability measures, and going concern issues.
Also, an informed analyst should keep in mind that present financing conditions may vary substantially between distressed and nondistressed companies. Similarly, the appropriate capital structure balance between debt and equity securities given the expected business risk as well as the impact of cost saving synergies, if any, should be assessed when looking at market transaction multiples.
Further, as with relative valuation, the use of “normalized” cash flow and alternative comparison multiples should help round out the picture of a company’s value beyond what may be derived from the market transaction multiples. This is especially true in situations in which the subject company has negative earnings or when traditional multiples do not capture the true expected earnings of the subject company.
The DCF approach is based on the premise that a company’s value is equal to the total amount of after-tax cash the company can generate for the benefit of its investors. Depending on the analysis, this can be done for all holders, including lenders, or for equity shareholders separately. Under the DCF approach, the value of a company is calculated by adding the present value of projected cash flows for a determined period to the present value of the residual or terminal value at the end of the projection period. The DCF approach requires a number of assumptions about the company, including:
- A projection of cash flows, including levels of growth, profitability, capital investment, and changes in working capital
- The appropriate length of the projection period
- The residual or terminal value at the end of the projection period (which may often be calculated by using market multiples)
- The discount rate, or weighted average cost of capital, used to discount the future cash flows back to the present period based on the assumed capital structure and expected cost of debt and equity financing
- The tax rate to be expected during the projection period
- The expected risk-free rate of interest, as well as the appropriate coefficient to reflect the correlation of the expected returns from the subject company against the expected returns from the market as a whole (the beta coefficient), during the projection period
Given the number of assumptions to be made by an investor, the DCF approach becomes particularly difficult in the context of distressed investments. Further, because the DCF approach is only as good as the assumptions made, actions taken by customers, suppliers, lenders, and other parties in interest during the company’s tenure in distress make this approach difficult, or even impossible, to complete with an appropriate level of comfort.
Even so, the factors that go into the DCF approach are important to understand and consider in assessing any company’s value, including those in distress. These factors should be considered in addition to any alternative relative valuation metrics to gauge a true value for any distressed company.
Bankruptcy Dynamic. The bankruptcy dynamic refers generally to unique restructuring-related issues that usually do not apply to nondistressed peers or competitors.
For example, investors should account for the impact of an out-of-court restructuring versus an in-court restructuring following a filing for bankruptcy protection. Restructuring mechanisms will impact the length of the case and, by extension, the length of the discount period during which investors must await future cash payments.
Time-consuming in-court restructurings are likely to result in higher professional fees and, as a result, smaller payouts to security holders compared to out-of-court restructurings. On the other hand, an in-court restructuring offers benefits that may outweigh the added costs, such as the ability to reject certain contracts that might otherwise reduce future cash flows to the company.
Another important element to consider in the context of the bankruptcy dynamic is the nature of a company’s capital structure. Seniority and subordination provisions, as set out in any outstanding credit documents, should be analyzed carefully to determine how the payment waterfall, if any, will accrue to creditors and other parties in interest of a distressed enterprise.
Similarly, outstanding litigation should be carefully assessed in the bankruptcy context, given that some legal claims, such as those involving toxic torts, asbestos claims, underfunded pension liabilities, or environmental issues, may receive seniority over most unsecured creditors during a bankruptcy.
In addition to the capital structure, generally a prospective investor should analyze, when possible, the nature of the holders of various outstanding securities. Questions to consider include:
- Who has the leverage, if any?
- Is the composition of ownership of each security level diversified or concentrated?
- Do any investors have blocking positions and, if so, is a “control premium” warranted for that investor or class of investors?
- What types of holders own the various securities — are they banks, insurance companies, structured credit funds, or perhaps certain types of hedge funds?
- How might the economic incentives of the different holders differ in the case at hand?
- Are different holders of the various securities likely to have different goals in terms of valuation and/or timing?
- Will these “soft issues” impact the likely outcome or the risk at different levels of the capital structure one way or another?
The bankruptcy dynamic has affected many investors negatively over the years. One recent high-profile example was Appaloosa Management’s entry into the Delphi Corporation bankruptcy. Early in the case, Appaloosa held 52 million of the bankrupt auto supplier’s shares and engaged in what many viewed as a smart strategic move to gain early control of the bankruptcy process.
Pre-petition equity holders in bankrupt companies, however, usually receive little or no recovery at the culmination of the bankruptcy process, and Appaloosa’s share ownership did not help it to control the process or compel the process to a different result. Delphi stock is trading at only cents on the dollar per share (as of mid-July), down from the peak of $3.65 in late 2006, at what would appear to be a significant loss to Appaloosa.
As this example shows, bankruptcy dynamics can trap even the most experienced investors. For those with little or no experience, distressed investing can be a minefield.
Liquidation Valuation. If the assets of a dissolved company appear to be more valuable individually than as part of a going-concern operation, a prospective investor should conduct a liquidation analysis. Typically, a liquidation analysis assesses the expected values from the sale of every asset on the company’s balance sheet. At least two different liquidation scenarios should be considered: one based on a forced sale of the company’s assets or operations and the other based on an orderly disposition of the company’s assets and liabilities over a longer period of time.
For companies operating in distress there often may be a substantial disconnect between book value under U.S. generally accepted accounting principles and “true market value.” Depending on the company, this may be evident not just in the book value of the total enterprise’s equity, but also in the book value of its various assets as disclosed on its most recent balance sheet.
For example, many of today’s distressed homebuilders have land option contracts on their balance sheets that require significant managerial assumptions to determine their balance sheet values. These assumptions include expiration date, volatility of price of the underlying asset, value of the underlying asset, time value decay, and the ability to exercise the option due to cash flow constraints, among other factors.
In addition to homebuilders, today’s distressed financial institutions, including banks, subprime lenders, investment banks, government-sponsored mortgage agencies, and monoline insurance companies, use broad managerial discretion in concluding on the value of the multiple assets on their balance sheets. As such, financial company assets, such as residual interests in securitized investment pools, derivatives, level three assets, or long-tailed liabilities, may have very wide valuation ranges, depending on the aggressiveness of assumptions that were employed by existing management.
One technique that often helps break through management’s subjective assumptions involves employing multiple scenarios in a liquidation analysis. A potential investor should assign three sets of return projections to each asset, roughly calculating “high,” “expected,” and “low” values based on experience and prudent judgment.
Liquidation analysis can also be helpful in generating valuations outside of what appear to be liquidation scenarios. For example, a liquidation valuation of Bear Stearns Companies in the months prior to its collapse and sale to JPMorgan would have shown that under any reasonable liquidation scenario the equity holders were highly unlikely to receive a recovery. A liquidation analysis of this kind would have yielded a strong bias toward a potentially very successful short sale of Bear’s common stock before the JPMorgan deal.
“Normalized” Cash Flow Projections. Whether or not a distressed entity has negative earnings, “normalized” cash flows may be helpful to measure the value of the company after a turnaround or upon exiting from bankruptcy. Historical cash flow and profitability levels during a company’s “healthy” period can help a potential investor identify “normalized” cash flow, though any such analysis must also take account of the current and expected future business environment.
Valuation of Tax Attributes. For companies that have recently emerged from bankruptcy, the analysis of net operating loss (NOL) tax attributes can become an important component of any valuation analysis. Investors can use historic NOLs to offset the payment of future cash income taxes. As such, with everthing else constant, eliminating or reducing the need to pay future income taxes increases the value of the enterprise to its equity owners.
The availability and value of NOLs can be reduced by the intricate change-of-control rules outlined in Section 382 of the Internal Revenue Code. Even so, some corporate debtors — such as those in distress due to asbestos claims — have more flexibility in developing reorganization plans that preserve a larger amount of NOLs for the benefit of the post-distress owners.
A good example of preserving NOL’s through a bankruptcy can be found in the Owens Corning asbestos-related bankruptcy. As noted in the company’s disclosure statement, the special provisions in the Bankruptcy Code relating to asbestos reorganizations allowed the company to preserve more than $2.8 billion in gross NOLs to offset future taxes.
The consideration of NOLs is generally reflected by adjustments to standard valuation techniques. For example, the DCF approach will account for after-tax cash flows when there is a material NOL simply by reducing the tax rate during the relevant period. A relative valuation analysis or use of market transaction multiples by an investor will simply add the expected present value of the NOL to the enterprise’s valuation. Either way, a thorough analysis of a distressed enterprise should include a consideration of the extent to which NOLs provide any material value to the company’s investors.
In addition to being more active, today’s distressed securities investment climate is also much more complex. Potential investors face much higher risk levels than in prior cycles. To generate a fully informed valuation for a subject company, experienced investors have learned to modify standard valuation techniques to a distressed entity to incorporate a variety of unique factors, including an analysis of the bankruptcy dynamic, a liquidation analysis, “normalized” cash flow projections, and the valuation of tax attributes.
These tools certainly will prove useful in coming years as the market forecasts increasing levels of distress. For those brave enough to take on the challenges, the technique will afford a higher probability of successfully crossing this investment minefield.