From January through May of this year, 39 E&P companies and 31 oilfield services companies had to file for bankruptcy. This post is the second of three aimed at helping those companies and any others who may face bankruptcy in the future to understand the valuation-related aspects of Chapter 11 restructuring. In the first post, we highlighted two reorganization requirements tied to valuation. Here we will explore the consequences of the first of those requirements:
The plan should demonstrate that the economic outcomes for the consenting stakeholders (creditors or equity holders) are superior under the Chapter 11 proceeding compared to a Chapter 7 proceeding, which provides for a liquidation of the business.
A Floor Value: Liquidation Value
If a company can no longer pay its debts and does not restructure, it will undergo Chapter 7 liquidation. Thus, this law simply mandates that Chapter 11 restructuring only be approved if it is stakeholders’ best option. Given this understanding of the law, the first valuation step in successful Chapter 11 restructuring is assessing the alternative, liquidation value. This value will be a threshold that any reorganization plan must outperform in order to be accepted by the court.
The value in liquidating a business is unfortunately not as simple as finding the fair market value, or even a book value for all the assets. The liquidation premise contemplates a sale of the company’s assets within a short period. Any valuation must account for the fact that inadequate time to place the assets in the open market means that the price obtained is usually lower than the fair market value.
In general, the discount from fair market value implied by the price obtainable under a liquidation premise is directly related to the liquidity of an asset. Accordingly, valuation analysts often segregate the assets of the petitioner company into several categories based upon the ease of disposal. Liquidation value is estimated for each category by referencing available discount benchmarks. For example, no haircut would apply to cash and equivalents, while reserves, and especially PUD and unproven reserves, would likely incur significant discounts. The size of this discount can be estimated by analyzing the prices commanded by comparable properties under a similarly distressed sale scenario. For instance, as mentioned in "Bridging Valuation Gaps: Part 1," the price Samson recently paid for properties in a distressed sale equaled the reserve report value of PDP and PDNPs. The discount was so steep that the company essentially received the PUD reserves for free.
Reorganization Value
Once an accurate liquidation value is established, the next step is determining whether the company can be reorganized in a way that provides more value to a company’s shareholders than discounted asset sales. ASC 852 defines1 reorganization value as:
“The value attributable to the reconstituted entity, as well as the expected net realizable value of those assets that will be disposed of before reconstitution occurs. This value is viewed as the value of the entity before considering liabilities and approximates the amount a willing buyer would pay for the assets of the entity immediately after restructuring.”
Typically the “value attributable to the reconstituted entity,” the new enterprise value for the restructured business, is the largest element of the total reorganization value. Unlike a liquidation, this enterprise value falls under what valuation professionals call a “going concern” value premise. This means that the business is not valued based on what one would be paid for selling individual assets, but rather the return that would be generated by the future operations of the emerging, restructured entity. To measure enterprise value in this way, reorganization plans primarily use a type of income approach, the discounted cash-flow (DCF) method. The DCF method estimates the net present value of future cash-flows that the emerging entity is expected to generate. Implementing the discounted cash-flow methodology requires three basic elements:
- Forecast of Expected Future Cash-flows. Guidance from management can be critical in developing a supportable cash-flow forecast. Generally, valuation specialists develop cash-flow forecasts for discrete periods that may range from three to ten years. Conceptually, one would forecast discrete cash-flows for as many periods as necessary until a stabilized cash-flow stream can be anticipated. Due to the opportunity to make broad strategic changes as part of the reorganization process, cash-flows from the emerging entity must be projected for the period when the company expects to execute its restructuring and transition plans. Major drivers of the cash-flow forecast include projected revenue, gross margins, operating costs and capital expenditure requirements. Historical experience of the petitioner company, as well as information from publicly traded companies operating in similar lines of business can provide reference points to evaluate each element of the cash-flow forecast.
- Terminal Value. The terminal value captures the value of all cash-flows after the discrete forecast period. Terminal value is determined by using assumptions about long-term cash-flow growth rate and the discount rate to capitalize cash-flow at the end of the forecast period. This means that the model takes the cash flow value for the last discrete year, and then grows it at a constant rate for perpetuity. In some cases the terminal value may be estimated by applying current or projected market multiples to the projected results in the last discrete year. An average EV/EBITDA of comparable companies, for instance, might be used to find a likely market value of the business at that date.
- Discount Rate. The discount rate is used to estimate the present value of the forecasted cash-flows. Valuation analysts develop a suitable discount rate using assumptions about the costs of equity and debt capital, and the capital structure of the emerging entity. Costs of equity capital are usually estimated by utilizing a build-up method that uses the long-term risk-free rate, equity risk premia, and other industry or company-specific factors as inputs. The cost of debt capital and the likely capital structure may be based on benchmark rates on similar issues and the structures of comparable companies. Overall, the discount rate should reasonably reflect the business and financial risks associated with the expected cash-flows of the emerging entity.
