More support for using more than just DCF (or other single method) in valuations

In re Chemtura Corp., 2010 WL 4272727 (Bkrtcy. S.D. NY.)(Oct. 29, 2010)

The Chemtura Corporation, a specialty chemical maker and its affiliates, filed for bankruptcy in March 2009—becoming the third major U.S. chemical manufacturer to succumb to the recession. A year later, the debtors proposed a plan of reorganization and settlement of claims. No creditors objected except the equity shareholders, who claimed it substantially undervalued the company.

The bankruptcy court held an independent valuation hearing, in which both the equity committee and the debtors presented expert evidence of total enterprise value (TEV), and the creditors presented a rebuttal expert to critique their approaches. The debtors’ expert valued the company from $1.9 to $2.2 billion, with a midpoint at $2.05 billion, and the shareholders’ expert concluded a range of TEV from $2.3 to $2.6 billion, with a midpoint at $2.45 billion. All the experts were from large investment banking firms, which played various advisory roles during the restructuring. In a 78-page opinion, the court discusses each expert’s approach, their assumptions as well as their possible bias, to determine whether the debtors’ TEV exceeded the value underpinning the proposed reorganization plan.

Adjustments to DCF for aggressive forecasts. To reach their respective total enterprise values, both the shareholders’ and the debtors’ experts used a discounted cash flow (DCF) analysis, with a similar range of discount rates, from 11.6% to 13.75%. Both relied on forecasts from the debtors’ long-range plan (LRP), which assumed the national economy would recover to pre-crisis levels by 2011 and the company’s earnings would grow during all five years of the forecast period. In their terminal value calculations, however, the experts differed significantly in selecting the earnings to which their multiples applied.

The shareholders’ expert applied its multiples to the earnings for the final forecast year, to reach a DCF value between $2.47 billion and $2.9 billion. By contrast, the debtors’ expert applied multiples of 6.5x to 7.5x from peer group averages and mid-cycle and normalized EBITDA to reach a TEV of $2.175 billion to $2.57 billion. The experts debated the extent of the debtors’ cyclicality, with the shareholders’ expert claiming that normalized earnings drove the present value down and the debtors’ expert saying the final year forecasted EBITDA—which exceeded all historic levels—led to a significantly overstated value. The creditors’ rebuttal expert agreed, believing the long-range forecasts were “overly” aggressive, based on unsupported assumptions of short-term economic growth, and requiring appropriate risk adjustments.

The court shared this skepticism regarding the company’s and the country’s growth. Although it might be more common to use final year cash flow projections to calculate terminal value, it said, in this case, the slow economic recovery plus the cyclical nature of the debtors’ business (or at least, the seasonality of its customers for agricultural and pool chemicals) supported the use of adjusted cash flows. “Taking the business cycle into account makes for a better analysis,” the court added, quoting Prof. Aswath Damodaran (NYU Stern School of Business) (Ups and Downs: Valuing Cyclical and Commodity Companies, 2009 ed.).

At the same time, the best normalization analysis would capture an entire business cycle—which the debtors’ expert did not do, the court pointed out. Despite this flaw, it found the debtors’ DCF analysis to be, on balance, more persuasive. If the economy were more stable, then it might consider the use of the final year’s cash flows to be “perfectly ordinary, if not preferred.” In the current economy, however, “relying on the very high terminal value in the last year of an admittedly aggressive string of growth projections is . . . too aggressive,” the court said. In addition, it was “troubled” that the shareholders’ expert made no effort to “address cyclicality at all.”

Market approach provides more than just a reality check. The court was also troubled that, unlike the debtors’ expert, the shareholders’ expert did not conduct a comprehensive analysis of comparable companies and comparable transactions to provide an independent value indicator, but simply used the market approach merely to test the reasonableness of its DCF.

“That’s disappointing,” the court said, especially as it found the comparable companies analysis to be more meaningful in this case than either the DCF approach, which is generally susceptible to uncertain projections, or the comparable transactions approach, which can be subject to control premiums, synergies, bidding wars, and hostile deals. For these reasons the court assigned the comparable companies approach the greatest overall weight in the case. In particular, it found the debtors’ analysis had “substantial” weight, based on the following:

1. The debtors’ expert examined 10 domestic comparables and five foreign, because the latter operated in the same global markets as the debtors and were subject to similar tax and regulatory environments. In addition, 50% of the debtors’ revenues came from foreign markets. Yet despite including foreign comparables in his “sum of the parts” and comparable transactions analysis, the shareholders’ expert left them out, here, further undercutting his criticism of the pool selected by the debtors’ expert.

2. The shareholders’ expert included two large multinational chemical corporations in his pool, but excluded a smaller specialty chemical company, which effectively inflated the overall multiples. The debtors’ expert excluded the large multinationals, because their sales, earnings, and enterprise values “dwarfed” the debtors’, but he included the smaller specialty company, which was more similar to the debtors in its size, product lines, and end-markets.

3. Both experts conducted a “sum-of-the-parts” analysis, but the debtors’ expert used the 2010 actual and projected numbers to derive its multiples and the shareholders’ expert used the more reliable multiples derived from 2011 earnings forecasts.

In addition, both experts applied the comparable transactions approach. The debtors’ expert reviewed 14 deals conducted between 2004 and 2010, worth between $1 billion and $10 billion. Given the material adversity caused by the global economic and capital markets crisis, however, the debtors’ expert ultimately relied on only three transactions occurring after September 2008 (when Lehman Bros. collapsed). Using their mean EBITDA multiple of 6.2x as a midpoint, the expert determined the debtors’ appropriate multiple range was 5.75x to 6.75x and applied this to Sept. 30, 2010, EBITDA to arrive at a range of TEV from $1.97 billion to $2.315 billion.

The shareholders’ expert examined 19 deals, which all closed prior to September 2010 with a much wider range of value, from $290 million to $18.66 billion, and a mean EBITDA multiple of 9.7x. But he did not calculate a TEV range from these multiples; instead, he took its estimated TEV range for the debtors to back-out EBITDA multiples of 6.9x and 7.9x. Since these back-calculated multiples were less than the 9.7x multiple for the comparable transactions, the shareholders’ expert concluded his TEV estimates did not exceed the debtors’ actual value.

Overall, the court found the shareholders’ expert’s heavy reliance on pre-Lehman transactions “was a serious flaw.” Advanced economies are “fundamentally different today,” the court observed, and “relying on multiples from a time period before the crash is inappropriate.” It also found flaws with the comparables selected by the debtors’ expert, noting that it included one with “dubious comparability” but omitted another which plainly should have been considered. However, with two post-Lehman comparables registering a 6.2x earnings multiple in the wake of the financial crisis, the court felt relatively comfortable in giving some weight to this methodology, especially since the upper end of the debtors’ transaction analysis was still well below the shareholders’ range of value under the DCF.

Market pricing and possible bias. If the court had to find a specific value for the debtors, it would have chosen an amount at the low end of the debtors’ range, it said. But to confirm the proposed reorganization plan as fair and reasonable, it needed only to find that the debtors’ TEV did not exceed the TEV underlying the plan, or $2.05 billion.

Based on all the expert evidence and analysis, “I so find,” the court said. Market information also supported its decision. During its restructuring attempts, the debtors cooperated with the equity committee in trying to find a buyer for the company, contacting nearly 20 potential investors using the committee’s $2.2 billion to $2.7 billion range of value. “But there were no takers, or offers, at that price or at any price that might ultimately lead” to such a value, the court said. Nor were any members of the equity committee—mostly hedge funds—willing to invest their own money into the debtors at that or even a lower price.

Moreover, under the proposed plan, the overwhelming majority of creditors and bondholders elected to take their recovery in cash rather than company stock. Once again, these stakeholders were highly sophisticated hedge funds and other “distressed debt” investors with the ability to dispose of stock. If they thought the plan undervalued the company, they would have “snapped up” the stock at the price offered by the equity committee, the court said. If they believed the valuation offered by the committee’s expert, “they really would have snapped it up,” it added, with emphasis. Their failure to do so and their preference for cash suggested they didn’t believe the stock was worth as much as the shareholders contended.

The court also found “exceptional” instances of witness bias in this case. The opinions of all the experts were influenced to some extent by their prior activities with the debtor, the circumstances under which they testified, and inconsistent testimony. In particular, the equity committee’s expert indicated a strong bias. To secure the engagement, he promised to be “aggressive in valuation” and to achieve “maximum value for the equity.” The terms of his engagement agreement provided, in addition to a monthly fee, a hefty “transaction fee” that turned on his ultimate valuation of TEV.

Similarly, both the debtors’ expert and the creditors’ experts received million-dollar fees upon the consummation of a plan. Although these fee provisions are fairly common ways to incentivize the investment bankers—and in this case, the court authorized their payment—the court couldn’t ignore the fees when the same bankers testified, finding the payment terms “materially” and “adversely” affected the experts’ credibility.

“Finally, failures by both [the debtors’] and [the shareholders’ expert] to change the midpoint of their valuations after the passage of time and in the face of seemingly different circumstances tend to undercut the persuasiveness of each,” the court held. For example, in June 2010, the shareholders’ expert valued the debtors within the range of $2.2 billion to $2.7 billion, with a midpoint of 2.45 billion. Three months later, it issued its trial valuation opinion within a narrower range--$2.3 billion to $2.6 billion—but with the precise same midpoint. The debtors’ expert likewise issued two separate valuations with the exact same midpoint, despite the company having achieved solid earnings in the interim coupled with the easing of uncertainty in national and global markets.

In both cases, the court found the coincidences were improbable, prompting it to be more “proactive in making [its] own valuation judgment rather than to accept [any] of the proffered ones.”  As a final matter, in addition to finding the proposed reorganization plan fair and reasonable, the court declined to disband the equity committee, leaving it intact to appeal this decision, if need be.  Stay tuned . . .