Chapter 11 reorganization affords a financially distressed or insolvent company an opportunity to restructure its liabilities and emerge as a sustainable going concern. Once a petition for Chapter 11 is filed with the bankruptcy court, the company usually undertakes a strategic review of its operations, including opportunities to shed assets or even lines of businesses. During the reorganization proceeding, stakeholders, including creditors and equity holders, negotiate and litigate to establish economic interests in the emerging entity. The Chapter 11 reorganization process concludes when the bankruptcy court confirms a reorganization plan which specifies a reorganization value and which reflects the agreed upon strategic direction and capital structure of the emerging entity.
In addition to fulfilling technical requirements of the bankruptcy code and providing adequate disclosure, two characteristics of a reorganization plan are germane from a valuation perspective:1
- The plan should demonstrate that the economic outcomes for the consenting stakeholders are superior under the Chapter 11 proceeding compared to a Chapter 7 proceeding, which provides for a liquidation of the business.
- Upon confirmation by the bankruptcy court, the plan will not likely result in liquidation or further reorganization.
- Within this context, valuation specialists can provide useful financial advice in order to:
- Establish the value of the business under a Chapter 7 liquidation premise.
- Measure the reorganization value of a business, which oulines both the haircuts required of pre-bankruptcy stakeholders and the capital structure of the emerging entity. A reorganization plan confirmed by a bankruptcy court establishes a reorganization value that exceeds the value of the company under a liquidation premise.
- Demonstrate the viability of the emerging entity’s proposed capital structure, including debt amounts and terms given the stream of cash-flows that can be reasonably expected from the business.
The value of a business under the liquidation premise contemplates a sale of the company’s assets within a short period. Inadequate time to place the assets in the open market means that the price obtained is usually lower than the fair market value.
In general, the discount from fair market value implied by the price obtainable under a liquidation premise is directly related to the liquidity of an asset. Accordingly, valuation analysts often segregate the assets of the petitioner company into several categories based upon the ease of disposal. Liquidation value is estimated for each category by referencing available discount benchmarks. For example, no haircut would apply to cash and equivalents while real estate holdings would likely incur potentially significant discounts, which could be estimated by analyzing the prices commanded by comparable properties under a similarly distressed sale scenario.
ASC 852 defines reorganization value as: “The value attributable to the reconstituted entity, as well as the expected net realizable value of those assets that will be disposed of before reconstitution occurs. This value is viewed as the value of the entity before considering liabilities and approximates the amount a willing buyer would pay for the assets of the entity immediately after restructuring.”2
Reorganization value is generally understood to be the value of the entity that emerges from the bankruptcy proceeding under a going concern premise of value. Typically, the largest element of the reorganization value is the business enterprise value of the emerging entity. Reorganization plans primarily make use of the discounted cash-flow (DCF) method under the income approach to measure the business enterprise value of the emerging entity. The DCF method estimates the net present value of future cash-flows that the emerging entity is expected to generate. Implementing the discounted cash-flow methodology requires three basic elements:
- Forecast of Expected Future Cash-flows: Guidance from management can be critical in developing a supportable cash-flow forecast. Generally, valuation specialists develop cash-flow forecasts for discrete periods that may range from three to ten years. Conceptually, one would forecast discrete cash-flows for as many periods as necessary until a stabilized cash-flow stream can be anticipated. Due to the opportunity to make broad strategic changes as part of the reorganization process, cash-flows from the emerging entity must be projected for the period when the company expects to execute its restructuring and transition plans. Major drivers of the cash-flow forecast include projected revenue, gross margins, operating costs and capital expenditure requirements. Historical experience of the petitioner company, as well as information from publicly traded companies operating in similar lines of business can provide reference points to evaluate each element of the cash-flow forecast.
- Terminal Value: The terminal value captures the value of all cash-flows beyond the discrete forecast period. Terminal value is typically determined by capitalizing cash-flow at the end of the forecast period, based on assumptions about long-term cash-flow growth rate and the discount rate. In some cases, the terminal value may be estimated through the application of curr ent or projected market multiples.
- Discount Rate: The discount rate is used to estimate the present value of the forecasted cash-flows. Valuation analysts develop a suitable discount rate using assumptions about the costs of equity and debt capital, and the capital structure of the emerging entity. Costs of equity capital are usually estimated by utilizing a build-up method that uses the long-term risk-free rate, equity premia, and other industry or company-specific factors as inputs. The cost of debt capital and the likely capital structure may be based on benchmark rates on similar issues and the structures of comparable companies. Overall, the discount rate should reasonably reflect the business and financial risks associated with the expected cash-flows of the emerging entity.
The sum of the present values of all the forecasted cash-flows, including discrete period cash-flows and the terminal value, provides an indication of the business enterprise value of the emerging entity for a specific set of forecast assumptions. The reorganization value is the sum of the expected business enterprise value of the emerging entity, plus proceeds from the sale or other disposal of assets during the reorganization, if any. During the reorganization proceeding, different stakeholders may independently develop distinct estimates of the reorganization value to facilitate negotiations or litigations. The confirmed reorganization plan, however, reflects the terms agreed upon by the consenting stakeholders and specifies either a single range of reorganization values or a single point estimate.
Bankruptcy courts may permit certain post petition liabilities to facilitate the operation of the petitioning business during the reorganization process. In conjunction with the reorganization plan, the courts also approve the amounts of allowed claims or interests for the stakeholders (creditors or equity holders) in the restructuring entity. The reorganization value is the value of the total assets of the emerging entity and represents all of the resources available to meet the post petition liabilities, and allowed claims and interests called for in the confirmed reorganization plan.
In principle, a confirmed reorganization plan should not lead to a liquidation or further restructuring in the foreseeable future. A cash-flow test evaluates the viability of a reorganization plan following the conclusion of the restructuring under Chapter 11 protection.
The first step in conducting the cash-flow test is to identify the cash-flows that underpin the reorganization plan. Conceptually, these cash-flows are available to service all the obligations of the emerging entity. As a matter of practice, since the reorganization value is usually developed using the DCF method, establishing the appropriate stream of cash-flows is often straightforward. Valuation analysts then need to model the negotiated or litigated terms attributable to the creditors of the emerging entity. In practice, this involves projecting interest and principal payments to the creditors, including any amounts due to providers of short term, working capital facilities.
Finally, the cash-flow test also documents the impact of the net cash-flows on the balance sheet of the emerging entity. This entails modeling changes in the asset base of the company as portions of the expected cash-flows are invested in working capital and capital equipment, as well as changes in the debt obligations of and equity interests in the company as the remaining cash-flows are disbursed to the capital providers. A reorganization plan is generally considered viable if such a detailed cash-flow model indicates solvent operations for the foreseeable future.
Managers of companies going through a Chapter 11 restructuring process need to juggle an extraordinary set of additional responsibilities — evaluating alternate strategies, implementing new and difficult business plans, and negotiating with various stakeholders — while continuing to operate the business. For this reason, it is common for a company that has filed for Chapter 11 to seek help from outside third party specialists to formulate a reorganization plan that can facilitate a successful navigation through the bankruptcy court. Valuation specialists can provide useful advice and perspective during the negotiation of the reorganization plan. The specialists can also help prepare the valuation and financial analysis necessary to satisfy the requirements for a reorganization plan to be confirmed by a bankruptcy court.
Travis W. Harms, CFA, CPA/ABV, leads Mercer Capital’s Financial Reporting Valuation Group. Harms’ practice focuses on providing public and private clients with fair value opinions and related assistance pertaining to goodwill and other intangible assets, stock-based compensation, and illiquid financial assets. In addition to his work with clients on financial statement reporting issues, Harms performs valuations used for tax compliance, ESOP compliance and other purposes for clients in a wide range of industries. Harms is a member of The Appraisal Foundation’s working group to address best practices for control premiums and co-authored the book Business Valuation: An Integrated Theory, Second Edition, with Z. Christopher Mercer, ASA, CFA, ABAR.
Sujan Rajbhandary, CFA, vice president, is a senior member of Mercer Capital’s Financial Reporting Valuation Group. The Financial Reporting Valuation Group provides fair value opinions and related advisory services to public companies, private companies and alternative investment vehicles. Rajbhandary has valued financial assets and liabilities for litigation support, tax compliance, ESOP compliance, and shareholder transactions. In 2010, Rajbhandary co-authored the book Valuation for Impairment Testing, Second Edition.