The ‘coronavirus-triggered economic downturn could lead to many performing loans to become distressed, especially for highly-leveraged companies,’ says a new client advisory from Houlihan Lokey, the global investment bank and valuation firm. The authors (Cindy Ma, Terence Tchen, Chris Cessna, and Andrew MacNamara) remind practitioners ‘when a debt security becomes distressed, a traditional [income approach] yield analysis may not be appropriate.’

Lenders may not receive contracted cash flows for industry-specific or company-specific reasons in addition to broad market volatility of the type we’re now seeing every day. Using a higher discount rate may not be enough to reflect the fair value of the distressed liability.

The authors advise analysts to watch for warning signs of financial distress including

[F]inancial metrics like insufficient enterprise value coverage or asset coverage, cash flow measures such as declining interest coverage ratio, the breach (or anticipated breach) of financial covenants, or other qualitative and quantitative indicators.

Houlihan Lokey offers business valuers a list of considerations when valuing distressed debt:

• What were the causes of the company’s underperformance?
• Is the underperformance temporary, or is it expected to continue? What are the company’s plans to address the underperformance and the costs associated with these plans?
• What are the expected future cash flows for the company and what are the risks around achieving these cash flows?
• What is the seniority of the distressed debt? Does it have any collateral or guarantees? Does the company have other securities that have a priority claim on company assets
• Is the borrower currently in default, or expected to be in default, under any of its credit agreements? If so, what are the likely outcomes (e.g., amend and extend, acceleration, voluntary or involuntary bankruptcy)? What is the timing of the outcomes and the probability of each outcome?
• What is a realistic enterprise value for the company? How much value coverage is there for the distressed debt?
• Does the company need to raise additional capital? If so, what form will that take and how will that impact the securities in the existing capital structure?
• Is a restructuring of the company likely? If so, will it be an in-court or out-of-court financial restructuring, and what are the implications on the valuation?
• Is a liquidation of company assets likely? If so, what are the expected recovery rates for each type of asset and how would those proceeds be distributed? Is the sale or closure of a business segment more likely?
• What are the expenses that would impact expected proceeds from a capital raise, restructuring, or liquidation?
• What are the negotiating dynamics between the various classes of debt and equity holders? Will this impact the allocation of proceeds differently than a simple waterfall through the capital structure?
• Is the borrower in default, or expected to be in default, under any of their credit agreements?

‘It is critical for the valuation provider to be fully transparent about the limitations of his or her analysis and the assumptions that are made in its preparation,’ the HL authors conclude.