The Challenge of Determining Enterprise Value in Volatile Markets

Two General Approaches to Valuation

Courts traditionally employ two approaches to determine value:

1. Testimony from dueling financial experts, each of whom applies the same three traditional valuation methodologies (comparable companies, precedent transactions, and discounted cash flow analyses), but exercises his or her judgment to reach separate subjective conclusions; and
2. A seemingly objective market test under which value is determined based on how much someone is actually willing to pay to purchase, or invest in, the debtor.

Each of these methods can yield a seriously flawed result. Determining value through expert reports is more of an art than a science. Experts often function more like advocates than objective seekers of truth. They reach dramatically different valuation conclusions by using their judgment to manipulate key inputs to arrive at a result that furthers their client's interests. As Judge Christopher S. Sontchi noted in In re Nellson Nutraceutical, Inc., No. 06-10072, 2007 WL 201134 at *30 (Bankr. D. Del. Jan. 18, 2007), “in virtually every instance that one of the ' experts chose to 'exercise judgment' rather than apply arithmetic, the effect of the exercise of that judgment was to lower the concluded value of the Debtors' enterprise value,” which in that case aided their clients' position. Because the three traditional valuation methodologies, to a greater or lesser extent, reflect the current state of the capital markets, they provide, at best, a snapshot of value on a particular date. In a depressed capital market (such as that which existed during much of 2008 and 2009), use of these three methodologies can yield low results which do not reflect the debtor's longer term “intrinsic” value.

The Market Test

As opposed to theoretical valuations, the market test arguably provides an empirical measure of value based only on transactions that can be consummated in the real world. As one court has observed, “people who must back their beliefs with their purses are more likely to assess the value of the [asset] accurately than are people who simply seek to make an argument.” In re Central Ice Cream Co., 836 F.2d 1068, 1072 n.3 (7th Cir. 1987). When there is little investment capital available, however, the market approach can also greatly understate long-term value. Investors and purchasers with cash are at a significant advantage and can gain what, in hindsight, will prove to be a bargain.

Opinions on value often merely reflect the self-interest of the clients that retain the expert who proffers them. In advocating for a lower valuation, senior creditors often assert that arguments for a higher valuation advanced by junior creditors' experts are not supported by any actual transaction that can be funded and closed. Experts for senior creditors or debtors, by contrast, often seek to support low valuations, which would allow such creditors or the debtor's senior management to receive a greater percentage of the reorganized entity's equity. See Stuart C. Gilson, Edith S. Hotchkiss and Richard S. Ruback, Valuation of Bankrupt Firms, 13 Rev. Fin. Studies 67 (2000) (finding evidence of an inherent bias toward understatement of value arising from senior management's receipt of stock and/or options in a reorganizing entity).

The 2006-2009 Period

An examination of what happened in the capital markets and bankruptcy cases over the past three or four years illustrates that value is an elastic concept in volatile markets. During 2006 and 2007, there was substantial liquidity in the marketplace and, not coincidentally, heightened merger and acquisitions activity. Later, in less frothy economic times, the prices paid in many of these transactions, particularly those financed with high debt levels based on overly optimistic projections of constant revenue and EBITDA growth, appeared to have been grossly inflated.

After the 2008 economic slowdown, many of these companies filed for bankruptcy because they could not meet their debt service. Because capital markets had almost totally dried up, debtors had trouble obtaining debtor-in-possession (“DIP”) or exit financing ' except, in many cases, from their existing senior creditors, who seemed to have viewed such financings, at best, as necessary to preserve and protect their original investments or, at worst, as a tool for acquiring control. For example, in early 2009, the court in In re Lyondell Chemical Co., No. 09-10023 (Bankr. S.D.N.Y Mar. 1, 2009) approved DIP financing from its prepetition senior secured creditors, which had an effective cost of over 20% and extremely tight timeframes for the debtors to propose a plan and emerge from Chapter 11, giving these senior secured creditors a major leg up in the plan process. The court found that these terms were fair and reasonable because they were the only ones on which credit was available in that market.

Because of the dearth of DIP financing, cases filed during this time tended to involve pre-packaged plans or Section 363 asset sales under which assets or equity went to senior creditors ' often over the objections of junior creditors who received no distribution. Depending on where they were in the capital structure, creditors viewed these plans as a realistic reflection of value then prevailing in a depressed marketplace ' or as conferring a windfall on senior creditor classes who sought to acquire these companies at a discount in the hope of reaping the benefits when more normal market conditions returned.

For example, in In re Motor Coach Industries International, No. 08-12136 (Bankr. D. Del. Jan. 28, 2009), the court confirmed a pre-negotiated plan in less than five months, over the objection of the official creditors' committee. This pre-negotiated plan, which was backed by committed exit financing, vested prepetition secured lenders with all of the reorganized debtor's equity. Unsecured creditors received no distribution.

During the second half of 2009 and early 2010, the capital markets have improved. Particularly over the last several months, DIP and exit financing have become readily available. The result has been plans premised on higher total enterprise values with valuation fights migrating down the capital structure, often resulting in requests for the appointment of official equity committees. See, e.g., Motion of Various Shareholders for an Order Appointing an Official Committee of Equity Security Holders, In re Visteon Corp., No. 09-11786 (Bankr. D. Del. Apr. 16, 2010); Motion for the Appointment of an Equity Security Holders Committee, In re Spansion, Inc., No. 09-10690 (Bankr. D. Del. June 8, 2009).

Six Flags

Perhaps the best illustration of how the changes in the capital markets have affected valuation and distribution in bankruptcy is the Premier International or Six Flags case. Six Flags filed for Chapter 11 in June 2009. Six Flags had a three-tiered capital structure with a holding company (Six Flags, Inc. – “SFI”), an intermediate holding company (Six Flags Operations, Inc. – “SFO”) and an operating company (Six Flags Theme Parks, Inc. ' “SFTP”). Shortly after the petition date, Six Flags announced that it had reached an agreement with its prepetition senior secured lenders under which they would receive 92% of the stock in the reorganized debtor and holders of structurally junior bonds issued by SFO, and SFI would receive only 7% and 1% of the postpetition equity respectively. This plan, which was premised on an implied total enterprise valuation of $1.25 billion, was opposed by the official creditors' committee and ad hoc groups of SFO and SFI noteholders as reflecting an artificially low enterprise value.

Last fall, an ad hoc group of holders of SFO bonds ' led by Avenue Capital and Fidelity ' proposed an alternative plan under which the prepetition banks were to be paid in full in cash from the proceeds of a $450 million rights offering and approximately $830 million in exit financing. Members of the SFO ad hoc noteholders group agreed to backstop the rights offering. Under this plan, SFO noteholders were to receive 95% of the equity in the reorganized debtor; SFI noteholders were to receive 5% of the equity. The SFO plan was premised on an enterprise value of approximately $1.4 to $1.5 billion.

Valuation Too Low?

While the SFO plan was premised on higher enterprise value than the original bank plan, and offered SFI holders 5% of the equity in the reorganized debtors instead of just 1%, the creditors' committee, together with an ad hoc group of SFI noteholders, viewed this plan as being premised on too low a valuation. The creditors' committee and the SFI ad hoc group argued that this valuation was depressed as a result of the debtors' experts' improper extrapolation from non-recurring factors that had depressed revenue and EBITDA in 2009 ' the recession, bad weather during the spring, and the swine flu epidemic.

As early as December, the SFI ad hoc noteholder group stated that they had arranged debt and equity financing to support a plan under which the claims of the senior secured banks and the SFO noteholders would be paid in full in cash and SFI noteholders would receive substantially all the equity in the reorganized debtors. The debtors and the SFO ad hoc noteholder group opposed this plan on the grounds that the SFI noteholders had not produced firm commitments for this financing and, in any event, such financing would leave the debtors with more debt than was feasible.

Faced with conflicting demands from the debtors and SFO noteholders to proceed to confirmation at the earliest possible date, and from the SFI noteholders and the official committee to delay confirmation and permit wide-ranging discovery, the bankruptcy court struck a middle ground ' scheduling a two-week confirmation trial for early March, while setting tight discovery deadlines. Relying on the same three general valuation methodologies, financial experts for the debtors and SFO ad hoc noteholders group submitted valuation reports in support of their contention that Six Flags' total enterprise value was approximately $1.5 billion; those for the official committee and the SFI ad hoc noteholder group submitted expert reports concluding that the debtors' value exceeded $1.9 billion.

A New Proposal

A few days before the trial, the SFI ad hoc noteholders group produced commitments for $1.25 billion in first and second lien exit financing and more than $500 million in new equity capital through a backstopped rights offering. The debtors rejected this proposal, asserting that it still would leave them with too much debt. After several days of trial, the SFI ad hoc noteholders amended their proposal to provide for substantially more equity and less debt and the Six Flags board adopted the plan. This plan was premised on an implied enterprise value of more than $1.8 billion, supported by actual market debt and equity commitments. As the chart below shows, the enterprise value underlying the SFI plan was approximately 50% higher than the initial approximately $1.25 billion valuation underlying the debtors' original bank plan and almost 25% higher than the valuation on which the SFO plan was premised.

Thus, in little more than six months, the debtors' total enterprise value had “increased” by more than 50%. In the end, the market test confirmed the valuation conclusions of the official committee and SFI ad hoc noteholders group's experts. During the three-month period, the Six Flags court allowed for a full-fledged valuation fight and the capital markets had thawed to the point where debt and equity financing to fund the SFI plan became available. Yet, it is not at all clear whether debt or equity financing could have been obtained to fund a plan premised on this value at an earlier point in the case.

Conclusion

Even in today's market, bankruptcy courts are often reluctant to afford junior creditors time to pursue an alternative plan which is not fully funded or is otherwise subject to significant execution risk. In Spansion, even where certain junior bondholders put hundreds of millions of dollars into escrow, the court refused to allow junior creditors the opportunity to pursue an alternative plan out of concerns that such plan was subject to significant delay risks and uncertainties. Findings of Facts, Conclusions of Law and Order Confirming Debtors' Second Amended Joint Plan of Reorganization, In re Spansion, Inc., No. 09-10690 (Bankr. D. Del. Apr. 16, 2010).

We will never know what would have happened if courts in cases such as Motor Coach had allowed the debtors to remain in Chapter 11 until market conditions improved. There are obviously limits on how long debtors can ' or ' should be permitted to linger in Chapter 11 in the hopes of a broad economic recovery. To be sure, certain types of cases cannot remain in Chapter 11 for long ' such as, for example, those involving debtors who are administratively insolvent or whose continued operations would result in large losses eroding senior creditors' positions or retailers who must reorganize before the end of the maximum 210-day period set by Bankruptcy Code ' 365(d)(4) by which they must assume or reject their leases.

Still, there is nagging uncertainty that valuation findings made when the markets were at their nadir were more a reflection of temporary extraordinary circumstances than the value these companies would have in more normal, steady state market conditions. Given this, we suggest that in every type of market, a greater effort needs to be made to attempt to filter out temporary conditions in a search for a more normalized value.

It should be noted that Brown Rudnick represented the following parties in the cited cases. In re Premier Int'l Holdings: Official Committee of Unsecured Creditors; In re Spansion, Inc.: Ad Hoc Consortium of Floating Rate Noteholders; In re Visteon Corp.: Official Committee of Unsecured Creditors; In re Motor Coach Industries International: Official Committee of Unsecured Creditors; In re Lyondell Chemical Co.: Official Committee of Unsecured Creditors.

Steven B. Levine (slevine@brown rudnick.com) is the Finance Practice Group Leader of Brown Rudnick LLP. He represents senior and junior lenders, hedge funds, official and unofficial committees and creditor groups in the documentation, structuring and recovery of complex financial transactions and restructurings. Andrew Dash ([email protected]) is a Partner in the firm's Litigation Department, specializing in complex commercial litigation, with particular emphasis in matters involving bankruptcy and creditor's rights, business valuation, contracts, commercial torts, and defamation. Jennifer M. Recht ([email protected]) is an Associate in the firm's Finance Group.

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Arguments about value lie at the heart of many disputes in Chapter 11 cases. Yet, despite how critical it is to the outcome of these cases, bankruptcy courts often have extreme difficulty determining value. This makes valuation a fertile source of litigation.

By examining several cases in which our firm had a meaningful role over the last two years, in particular In re Premier International Holdings (Six Flags), No. 09-12019 (Bankr. D. Del. 2009), we illustrate how short term capital market trends can affect valuation, and the limitations of the two standard approaches courts use to determine value ' opinions of financial experts and actual market transactions. Where markets are illiquid, the desire to move cases through the system often is in conflict with the goals of maximizing and fairly distributing value to creditors. Where overall values are temporarily depressed, courts need to be cautious that junior creditors are not deprived of their share of the long-term “intrinsic” value a debtor would have under more steady state conditions while senior creditors may receive a windfall.

Given this, courts should approach the valuation issue in a nuanced and balanced fashion ' cognizant of the difficulties inherent in their task. Practical experience shows that there should be no hard and fast rule as to which approach works in all cases. Rather, courts should allow time for the adversary process to play out and apply their expertise and judgment on a case-by-case basis, conscious of how temporary market conditions can impact value.

Two General Approaches to Valuation

Courts traditionally employ two approaches to determine value:

1. Testimony from dueling financial experts, each of whom applies the same three traditional valuation methodologies (comparable companies, precedent transactions, and discounted cash flow analyses), but exercises his or her judgment to reach separate subjective conclusions; and
2. A seemingly objective market test under which value is determined based on how much someone is actually willing to pay to purchase, or invest in, the debtor.

Each of these methods can yield a seriously flawed result. Determining value through expert reports is more of an art than a science. Experts often function more like advocates than objective seekers of truth. They reach dramatically different valuation conclusions by using their judgment to manipulate key inputs to arrive at a result that furthers their client's interests. As Judge Christopher S. Sontchi noted in In re Nellson Nutraceutical, Inc., No. 06-10072, 2007 WL 201134 at *30 (Bankr. D. Del. Jan. 18, 2007), “in virtually every instance that one of the ' experts chose to 'exercise judgment' rather than apply arithmetic, the effect of the exercise of that judgment was to lower the concluded value of the Debtors' enterprise value,” which in that case aided their clients' position. Because the three traditional valuation methodologies, to a greater or lesser extent, reflect the current state of the capital markets, they provide, at best, a snapshot of value on a particular date. In a depressed capital market (such as that which existed during much of 2008 and 2009), use of these three methodologies can yield low results which do not reflect the debtor's longer term “intrinsic” value.

The Market Test

As opposed to theoretical valuations, the market test arguably provides an empirical measure of value based only on transactions that can be consummated in the real world. As one court has observed, “people who must back their beliefs with their purses are more likely to assess the value of the [asset] accurately than are people who simply seek to make an argument.” In re Central Ice Cream Co., 836 F.2d 1068, 1072 n.3 (7th Cir. 1987). When there is little investment capital available, however, the market approach can also greatly understate long-term value. Investors and purchasers with cash are at a significant advantage and can gain what, in hindsight, will prove to be a bargain.

Opinions on value often merely reflect the self-interest of the clients that retain the expert who proffers them. In advocating for a lower valuation, senior creditors often assert that arguments for a higher valuation advanced by junior creditors' experts are not supported by any actual transaction that can be funded and closed. Experts for senior creditors or debtors, by contrast, often seek to support low valuations, which would allow such creditors or the debtor's senior management to receive a greater percentage of the reorganized entity's equity. See Stuart C. Gilson, Edith S. Hotchkiss and Richard S. Ruback, Valuation of Bankrupt Firms, 13 Rev. Fin. Studies 67 (2000) (finding evidence of an inherent bias toward understatement of value arising from senior management's receipt of stock and/or options in a reorganizing entity).

The 2006-2009 Period

An examination of what happened in the capital markets and bankruptcy cases over the past three or four years illustrates that value is an elastic concept in volatile markets. During 2006 and 2007, there was substantial liquidity in the marketplace and, not coincidentally, heightened merger and acquisitions activity. Later, in less frothy economic times, the prices paid in many of these transactions, particularly those financed with high debt levels based on overly optimistic projections of constant revenue and EBITDA growth, appeared to have been grossly inflated.

After the 2008 economic slowdown, many of these companies filed for bankruptcy because they could not meet their debt service. Because capital markets had almost totally dried up, debtors had trouble obtaining debtor-in-possession (“DIP”) or exit financing ' except, in many cases, from their existing senior creditors, who seemed to have viewed such financings, at best, as necessary to preserve and protect their original investments or, at worst, as a tool for acquiring control. For example, in early 2009, the court in In re Lyondell Chemical Co., No. 09-10023 (Bankr. S.D.N.Y Mar. 1, 2009) approved DIP financing from its prepetition senior secured creditors, which had an effective cost of over 20% and extremely tight timeframes for the debtors to propose a plan and emerge from Chapter 11, giving these senior secured creditors a major leg up in the plan process. The court found that these terms were fair and reasonable because they were the only ones on which credit was available in that market.

Because of the dearth of DIP financing, cases filed during this time tended to involve pre-packaged plans or Section 363 asset sales under which assets or equity went to senior creditors ' often over the objections of junior creditors who received no distribution. Depending on where they were in the capital structure, creditors viewed these plans as a realistic reflection of value then prevailing in a depressed marketplace ' or as conferring a windfall on senior creditor classes who sought to acquire these companies at a discount in the hope of reaping the benefits when more normal market conditions returned.

For example, in In re Motor Coach Industries International, No. 08-12136 (Bankr. D. Del. Jan. 28, 2009), the court confirmed a pre-negotiated plan in less than five months, over the objection of the official creditors' committee. This pre-negotiated plan, which was backed by committed exit financing, vested prepetition secured lenders with all of the reorganized debtor's equity. Unsecured creditors received no distribution.

During the second half of 2009 and early 2010, the capital markets have improved. Particularly over the last several months, DIP and exit financing have become readily available. The result has been plans premised on higher total enterprise values with valuation fights migrating down the capital structure, often resulting in requests for the appointment of official equity committees. See, e.g., Motion of Various Shareholders for an Order Appointing an Official Committee of Equity Security Holders, In re Visteon Corp., No. 09-11786 (Bankr. D. Del. Apr. 16, 2010); Motion for the Appointment of an Equity Security Holders Committee, In re Spansion, Inc., No. 09-10690 (Bankr. D. Del. June 8, 2009).

Six Flags

Perhaps the best illustration of how the changes in the capital markets have affected valuation and distribution in bankruptcy is the Premier International or Six Flags case. Six Flags filed for Chapter 11 in June 2009. Six Flags had a three-tiered capital structure with a holding company (Six Flags, Inc. – “SFI”), an intermediate holding company (Six Flags Operations, Inc. – “SFO”) and an operating company (Six Flags Theme Parks, Inc. ' “SFTP”). Shortly after the petition date, Six Flags announced that it had reached an agreement with its prepetition senior secured lenders under which they would receive 92% of the stock in the reorganized debtor and holders of structurally junior bonds issued by SFO, and SFI would receive only 7% and 1% of the postpetition equity respectively. This plan, which was premised on an implied total enterprise valuation of $1.25 billion, was opposed by the official creditors' committee and ad hoc groups of SFO and SFI noteholders as reflecting an artificially low enterprise value.

Last fall, an ad hoc group of holders of SFO bonds ' led by Avenue Capital and Fidelity ' proposed an alternative plan under which the prepetition banks were to be paid in full in cash from the proceeds of a $450 million rights offering and approximately $830 million in exit financing. Members of the SFO ad hoc noteholders group agreed to backstop the rights offering. Under this plan, SFO noteholders were to receive 95% of the equity in the reorganized debtor; SFI noteholders were to receive 5% of the equity. The SFO plan was premised on an enterprise value of approximately $1.4 to $1.5 billion.

Valuation Too Low?

While the SFO plan was premised on higher enterprise value than the original bank plan, and offered SFI holders 5% of the equity in the reorganized debtors instead of just 1%, the creditors' committee, together with an ad hoc group of SFI noteholders, viewed this plan as being premised on too low a valuation. The creditors' committee and the SFI ad hoc group argued that this valuation was depressed as a result of the debtors' experts' improper extrapolation from non-recurring factors that had depressed revenue and EBITDA in 2009 ' the recession, bad weather during the spring, and the swine flu epidemic.

As early as December, the SFI ad hoc noteholder group stated that they had arranged debt and equity financing to support a plan under which the claims of the senior secured banks and the SFO noteholders would be paid in full in cash and SFI noteholders would receive substantially all the equity in the reorganized debtors. The debtors and the SFO ad hoc noteholder group opposed this plan on the grounds that the SFI noteholders had not produced firm commitments for this financing and, in any event, such financing would leave the debtors with more debt than was feasible.

Faced with conflicting demands from the debtors and SFO noteholders to proceed to confirmation at the earliest possible date, and from the SFI noteholders and the official committee to delay confirmation and permit wide-ranging discovery, the bankruptcy court struck a middle ground ' scheduling a two-week confirmation trial for early March, while setting tight discovery deadlines. Relying on the same three general valuation methodologies, financial experts for the debtors and SFO ad hoc noteholders group submitted valuation reports in support of their contention that Six Flags' total enterprise value was approximately $1.5 billion; those for the official committee and the SFI ad hoc noteholder group submitted expert reports concluding that the debtors' value exceeded $1.9 billion.

A New Proposal

A few days before the trial, the SFI ad hoc noteholders group produced commitments for $1.25 billion in first and second lien exit financing and more than $500 million in new equity capital through a backstopped rights offering. The debtors rejected this proposal, asserting that it still would leave them with too much debt. After several days of trial, the SFI ad hoc noteholders amended their proposal to provide for substantially more equity and less debt and the Six Flags board adopted the plan. This plan was premised on an implied enterprise value of more than $1.8 billion, supported by actual market debt and equity commitments. As the chart below shows, the enterprise value underlying the SFI plan was approximately 50% higher than the initial approximately $1.25 billion valuation underlying the debtors' original bank plan and almost 25% higher than the valuation on which the SFO plan was premised.

Thus, in little more than six months, the debtors' total enterprise value had “increased” by more than 50%. In the end, the market test confirmed the valuation conclusions of the official committee and SFI ad hoc noteholders group's experts. During the three-month period, the Six Flags court allowed for a full-fledged valuation fight and the capital markets had thawed to the point where debt and equity financing to fund the SFI plan became available. Yet, it is not at all clear whether debt or equity financing could have been obtained to fund a plan premised on this value at an earlier point in the case.

Conclusion

Even in today's market, bankruptcy courts are often reluctant to afford junior creditors time to pursue an alternative plan which is not fully funded or is otherwise subject to significant execution risk. In Spansion, even where certain junior bondholders put hundreds of millions of dollars into escrow, the court refused to allow junior creditors the opportunity to pursue an alternative plan out of concerns that such plan was subject to significant delay risks and uncertainties. Findings of Facts, Conclusions of Law and Order Confirming Debtors' Second Amended Joint Plan of Reorganization, In re Spansion, Inc., No. 09-10690 (Bankr. D. Del. Apr. 16, 2010).

We will never know what would have happened if courts in cases such as Motor Coach had allowed the debtors to remain in Chapter 11 until market conditions improved. There are obviously limits on how long debtors can ' or ' should be permitted to linger in Chapter 11 in the hopes of a broad economic recovery. To be sure, certain types of cases cannot remain in Chapter 11 for long ' such as, for example, those involving debtors who are administratively insolvent or whose continued operations would result in large losses eroding senior creditors' positions or retailers who must reorganize before the end of the maximum 210-day period set by Bankruptcy Code ' 365(d)(4) by which they must assume or reject their leases.

Still, there is nagging uncertainty that valuation findings made when the markets were at their nadir were more a reflection of temporary extraordinary circumstances than the value these companies would have in more normal, steady state market conditions. Given this, we suggest that in every type of market, a greater effort needs to be made to attempt to filter out temporary conditions in a search for a more normalized value.

It should be noted that Brown Rudnick represented the following parties in the cited cases. In re Premier Int'l Holdings: Official Committee of Unsecured Creditors; In re Spansion, Inc.: Ad Hoc Consortium of Floating Rate Noteholders; In re Visteon Corp.: Official Committee of Unsecured Creditors; In re Motor Coach Industries International: Official Committee of Unsecured Creditors; In re Lyondell Chemical Co.: Official Committee of Unsecured Creditors.

Steven B. Levine (slevine@brown rudnick.com) is the Finance Practice Group Leader of Brown Rudnick LLP. He represents senior and junior lenders, hedge funds, official and unofficial committees and creditor groups in the documentation, structuring and recovery of complex financial transactions and restructurings. Andrew Dash ([email protected]) is a Partner in the firm's Litigation Department, specializing in complex commercial litigation, with particular emphasis in matters involving bankruptcy and creditor's rights, business valuation, contracts, commercial torts, and defamation. Jennifer M. Recht ([email protected]) is an Associate in the firm's Finance Group.

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