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 last in a series 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. First, the plan should demonstrate that the economic outcomes for the consenting stakeholders are superior under the Chapter 11 proceeding compared to a Chapter 7 proceeding. Second, upon confirmation by the bankruptcy court, the plan must not be likely to result in liquidation or further reorganization. In the second post we explored in depth the consequences of the first requirement. Here we examine the importance of the second requirement.
Cash-Flow Test
For a company that has followed the steps explained in the previous post, this second requirement represents the last valuation hurdle to successfully emerging from Chapter 11 restructuring. Even if a company shows that the restructuring plan will benefit stakeholders more than liquidation will, the court will still reject the plan if it is likely to lead to liquidation or further restructuring in the foreseeable future. To satisfy the court, a cash-flow test is used to analyze whether the restructured company would generate enough cash to consistently pay its debts. This cash-flow test can be broken into three parts.
The first step in conducting the cash-flow test is to identify the cash-flows that the restructured company will generate. These cash-flows are available to service all the obligations of the emerging entity. Remember the discussion in the second post—a stream of cash-flows is developed using the DCF method in order to determine the reorganization value. Thus, in practice, establishing the appropriate stream of cash-flows for the cash-flow test is often a straightforward matter of using these projected cash-flows in the new model.
Once the fundamental cash-flow projections are incorporated, analysts then model the negotiated or litigated terms attributable to the creditors of the emerging entity. This involves projecting interest and principal payments to the creditors, including any amounts due to providers of short term, working capital facilities. These are the payments for each period that the cash-flow generated up to that point must be able to cover in order for the company to avoid another bankruptcy.
The cash-flows of the company will not be used only to pay debts, and so the third and final step in the cash-flow test is documenting the impact of the net cash-flows on the entire balance sheet of the emerging entity. This entails modeling changes in the company’s asset base as portions of the expected cash-flows are invested in working capital and capital equipment; and modeling changes in the debt obligations of and equity interests in the company as the remaining cash-flows are disbursed to the capital providers. A reorganization plan is generally considered viable if such a detailed cash-flow model indicates solvent operations for the foreseeable future.
Conclusion
Although the Chapter 11 process can seem like no more than a burden, a rigorous assessment of cash-flows and a company’s capital structure can help the company as it tries to develop a plan for years of future success. We hope that these past three posts explaining the key valuation-related steps of a Chapter 11 restructuring help managers realize this potential.
However, we also understand that executives of oil and gas companies going through a Chapter 11 restructuring process need to juggle an extraordinary set of additional responsibilities—evaluating alternate strategies, implementing new and difficult business plans, and negotiating with various stakeholders. Given executives’ multitude of other responsibilities, they often decide that it is best to seek help from outside, third party specialists. Valuation specialists can relieve some of the burden from executives by developing the valuation and financial analysis necessary to satisfy the requirements for a reorganization plan to be confirmed by a bankruptcy court. Specialists can also provide useful advice and perspective during the negotiation of the reorganization plan to help the company emerge with the best chance of success. With years of experience in both oil and gas, and in bankruptcy, at Mercer Capital, we are well positioned to help in both of these roles. For a confidential conversation about bankruptcy proceedings and how we can help, please contact a Mercer Capital professional.
