Asset valuation is the cornerstone of business litigation and restructuring. That is why we focus on optimizing valuation in every part of our work. If valuations are correct, strategic litigation can likely stay on track for success. The same can be said for a reorganization plan and creditor strategies in restructuring or Chapter 11 cases. Because asset valuation is so critical to successful reorganization, we spend an inordinate amount of time in addressing valuation methods and metrics, in the context of current information and economic data.
Authoritative Article by Chief Judge Sontchi (D.Delaware)
Valuation metrics used in contest proceedings (covering business litigation and bankruptcy proceedings) are outlined out in the authoritative paper, “Valuation Methodologies: a Judge’s View by Bankruptcy Judge Christopher S. Sontchi (Chief Judge, D.Delaware). A company and/or its assets can be valued in one of four ways (as paraphrased in this section, below):
1. Estimation of current asset values, typically using liquidation value or replacement value;
2. Discount of expected cash flows of a going-concern business (DCF);
3. Relative value analysis of comparable companies / assets; and
4. Contingent event assessment.
We review these in order:
ASSET VALUATION: Liquidation Value
Liquidation value, at first blush, seems less useful than, say, discounted cash flow analysis or comparable sale analysis. However in a Chapter 11 setting, this value takes on significance because a standard Chapter 11 debtor must show, for Plan confirmation, that each claim-holder has either voted for plan confirmation or would otherwise receive no less than liquidation value under a Chapter 7 proceeding.
asset valuation: Discounted Cash Flow OF A GOING CONCERN
The discounted cash flow method assumes that the value of an asset is the present value of expected future cash flows from it, reduced by a discount rate that contemplates risk and the cost of capital. The cash flow projections used for valuation typically come from management’s estimates of future performance. As such, cash flow estimates are necessarily subject to uncertainty relating to matters specific to the firm as well as to broader issues such as the general state of the economy.
asset valuation: Comparable Asset
In comparable valuation, the value of an asset is derived from the pricing of comparable assets, standardized using a common variable, such as, e.g., EBITDA. Unlike discounted cash flow valuation, which is a search for intrinsic value, relative valuation is a search for market value. In this analysis, one assumes that the market is correct in the way it prices assets and firms on average.
The two most common comparable bankruptcy asset valuation methodologies used in chapter 11 cases are the comparable companies analysis and the comparable transactions analysis. Under both methods, one determines a metric by which to value the company such as EBITDA. One then looks to either comparable publicly-traded companies or control transactions involving comparable companies to determine the appropriate multiple to apply to the selected metric to reach a conclusion of the target asset value.
Bankruptcy asset valuation: Contingent EventS
The premise underlying the use of option pricing models in valuation is that discounted cash flow models tend to understate the value of assets that provide payoffs that are contingent on the occurrence of an event.
As per Chief Judge Sontchi: “[f]or example, consider undeveloped oil reserves. One could value this oil reserve based on expectations of oil prices in the future but this estimate would miss the fact that the oil company will develop the reserve only if oil prices go up and will not if oil prices decline. An option pricing model would yield a value that incorporates this right.”
Typical Valuation Errors
Valuation errors arise, often with drastic results to one party or another, if value assumptions are incorrect or otherwise misleading.
For example, in the reorganization of UAL Corp, United Airlines valued its frequent flyer program using a liquidation method, assuming frequent flyer miles were liabilities instead of assets. This resulted in the United Mileage Plus program being given a $0 value in bankruptcy. It later turned out that United mortgaged its Mileage Plus program for $5.3 billion to raise operating cash.
Meanwhile, in the earlier bankruptcy proceedings, Judge Eugene Wedoff (now retired) allowed to jettison its employee pension program for “lack of assets” to support ongoing pension payments, on the premise that, in part, Mileage Plus held a $0 value. Judge Wedoff’s ruling cleared the way for United to monetize its Mileage Plus program rather than continuing to fund employee pension plans. This particular ruling is an example of an incorrect bankruptcy asset valuation method (liquidation value) applied to an otherwise valuable asset, which resulted in termination of employee pension plans.
In another example in an open case in the Nevada Bankruptcy Court, a parcel of land adjacent to a golf course was valued based on its then-applicable zoning that required public access. This resulted in a secured creditor losing a very material portion of its secured claim. Subsequently, prior to the plan effective date, the property was rezoned to allow residential construction. The change in zoning materially affected asset value of the land, creating a windfall for debtor, while leaving the creditor significantly under-secured.
Counsel for creditors needs to be vigilant in understanding the basis for valuations, and the possibility for any change in the use of the asset that will create a higher valuation.