A number of issues have emerged that analysts will encounter when performing a valuation in a bankruptcy context. Valuation analysts who become involved in bankruptcy-related assignments should expect their work to come under a great deal of scrutiny because most of these engagements are done within a litigation or some other adversarial context, cautioned Robert Reilly, a managing director at Willamette Management Associates, during a BVR webinar back in 2017. While his remarks were made a few years ago, they continue to resonate, and a chapter from Business Valuation and Bankruptcy: Case Law Compendium, 3rd edition, contains more of his timeless advice on how to handle the challenges valuation experts will face.
- Limited guidance on definition of ‘value.’ The U.S. Bankruptcy Code doesn’t define any standard of value. The closest you’ll find is in Bankruptcy Code Section 506a, which states that “value shall be determined in light of the purpose of the valuation [emphasis added] and of the proposed disposition or use of such property, and in conjunction with any hearing on such disposition or use or on a plan affecting such creditor’s interest.” Analysts and legal counsel will need to look to judicial precedent to see what value definitions the courts have accepted. The trouble is you’ll still find limited guidance as to which standard of value is appropriate in which bankruptcy circumstances.
Tip: Be familiar with the relevant sections of the Bankruptcy Code and the Bankruptcy Rules, but you should not be making legal decisions. Do not hesitate to ask for legal instructions from counsel with regard to any bankruptcy-related legal issues.2. Hindsight is discouraged. The use of hindsight is an issue with most all valuations, but it’s particularly controversial in a bankruptcy context because everybody knows what actually happened to the debtor company (it filed for bankruptcy protection), so the tendency to use hindsight is quite common. Most bankruptcy valuations use a retrospective valuation date because there’s a specific historical event that triggered the distress, such as a dividend payment or a financing transaction. There is usually controversy over when the actual debtor company events would have been known or knowable.
Tip: The courts seem to adopt the known or knowable rule, Reilly says. You should consider only that information that was known or knowable as of the time of the valuation date.
3. Reliance on management projections. In a bankruptcy context, it is not uncommon for debtor company management to prepare various financial projection versions. One version could be prepared for the debtor board, one for the debtor’s bank, one for a potential acquirer, and maybe others. In this case, you should perform sufficient due diligence regarding these projections to conclude which version is most appropriate for the purpose and objective of the bankruptcy valuation. If possible, you should avoid relying on projections prepared after the bankruptcy litigation is filed. Even if such post-petition filing projections are perfectly reasonable, some party in interest may allege that the projections are biased and litigation-driven. Also, try to learn who prepared the projections and whether those individuals were qualified to do it.
Tip: If you say that you relied on management’s projections, be prepared for this question from the judge: “So these projections were prepared by management. This is the same management team that led this company into bankruptcy today. Why are you relying on this management team again? Obviously, they didn’t do a very good job of managing the company.” Good point, and that’s probably right, but that may be the most reliable data you have available. You need to take that into consideration and be ready to explain.
4. Debt interest rates. The current commercial debt interest rates may be considered unreasonably low, Reilly points out. You need to determine whether the use of such interest rates is appropriate in determining the debtor company weighted average cost of capital (WACC).
Tip: An unreasonably low cost of debt can understate WACC, which may overstate the debtor company value. Ask yourself this question: If the debtor company obtained new financing today, could it actually enjoy the benefit of current relatively low interest rates?
5. Due diligence. Rest assured that you will always be questioned on the reasonableness of your due diligence because you typically have limited access to financial or operational documents (troubled firms are lax in filing documents) and company management has typically moved on, so you may not even be able to talk with certain key people.
Tip: Keep in mind that “hindsight is always 20-20” and it’s easy for the opposition to point out that everyone knows what really happened. So be prepared to show that you did enough due diligence to be convinced that the valuation was correct as of the valuation date.
6. Rules of thumb. The bankruptcy court does not look very favorably on rules of thumb, notes Reilly. If they apply at all, they may apply to an average company in that industry, but your subject company is in financial distress, so it’s probably not average.
Tip: Do not use industry rules of thumb as a primary valuation method. If rules of thumb are used at all, they should be supported by actual empirical data.
Of course, this just hits the high points of one facet of valuations in a bankruptcy context. One interesting piece of advice Reilly gave when summing up is that your valuation report should be “your best friend,” available at your fingertips to help you answer every question you will face. But, to fulfill this role, your report must be clear, convincing, and cogent. It also must be replicable, transparent, and well-supported with source documents. Then you can answer every question by starting with “As I said in my report,” which will heighten your credibility.
To see the complete list of tips on how to handle issues in bankruptcy valuations or to learn more about bankruptcy as it relates to business valuation, be sure to check out BVR’s Business Valuation and Bankruptcy: Case Law Compendium, 3rd edition. Preview the table of contents and look inside to learn more about this invaluable resource for business valuation professionals to stay ahead of the game.