The conventions for defining value may never be more important than when making decisions related to business continuity and financial restructuring. Countless clients have demonstrated a sense of confusion regarding the various descriptors of value used in valuation settings. More than a few valuation stakeholders have mused that the value of anything (a business or an asset as the case may be) should be an absolute numerical expression and unambiguous in meaning. Unfortunately for those seeking simplicity in a trying time, the conditional cliché “it depends” is critical when defining value for the assessment of bankruptcy decisions and workout financing. The elements that underpin the Premise of Value provide a convenient base for introducing some of the vocabulary used in the bankruptcy and restructuring environment. Gaining a thorough familiarity with the Premise of Value provides a cornerstone for understanding the financial considerations employed in valuing business assets and evaluating financial options.
Defining value is a science of its own and can be subject to debate based on facts and circumstances. With respect to business enterprises and assets, as well as business ownership interests, there are numerous defining elements of value. These elements generally include the Standard of Value, the Level of Value, and the Premise of Value. More confusing is that real property appraisers, machinery & equipment appraisers and corporate valuation advisors may not use the same value-defining nomenclature and may have varied meanings for similar vocabulary. When the question of business value or asset value arises, the purpose of the valuation, the venue or jurisdiction in which value is being determined and numerous other facts and circumstances have a bearing on the defining elements of value.
Everyone has seen the “inventory liquidation sale” sign or the “going out of business” sign in the shop window. For the merchant and the merchant’s capital providers, the ramifications of how assets are monetized for the purposes of optimizing returns on and of capital is a key focus of the valuation methods employed in the restructuring and bankruptcy environment. The international glossary of business valuation terms defines the Premise of Value and its components as follows:
The Premise of Value is a swing consideration for distressed businesses and their lenders. For businesses in financial distress, achieving a return on capital shifts to the priority of asset protection and capital value preservation via a deliberate plan to mitigate downside exposures. In most situations where a business is dealing with an existential financial threat, the preference for the business is to remain a Going Concern (at least initially), whereby the business continues to operate as a re-postured version of its former self. In the context of bankruptcies and/or restructurings, the business that remains a Going Concern is referred to as the Debtor in Possession (DIP).
DIPs remain a Going Concern using the protection of Chapter 11 bankruptcy to achieve a fresh start where their financial obligations are restructured through modification and/or specialized refinancing. Chapter 11 involves a detailed plan of reorganization, which may be administered by a trustee and is ultimately governed under the specialized legal oversight of the courts. Reorganization under Chapter 11 is the preferred first step for most operating enterprises whose business assets are purpose?specific and for which the break-up value of the assets would be economically punitive to capital investors. Intuitive to the Going Concern premise are valuation methods and analyses that study potential business outcomes using detailed forecasts and the corresponding potential of the resulting cash flows to service the necessary financing to achieve the outcome. One valuation discipline among numerous possibilities is the establishment and testing of a value threshold at which the capital returns are deemed adequate to their respective providers (e.g. an IRR analysis) based on the risks incurred. If remaining a Going Concern delivers an acceptable rate of return under a plan of reorganization, then liquidation might be avoided or forestalled.
The alternative to remaining a Going Concern involves the process of liquidation. In bankruptcy terms, a business entity files for Chapter 7 and begins the cessation of business operations and seeks a sale of assets to re-pay creditors based the creditors’ respective position in the capital stack. The “liquidation” premise is generally a value-compromising proposition for the bankruptcy stakeholders with the economic consequences are scaled to whether the liquidation is achieved in an orderly process or a forced process.
Modern, global economies and increasingly technology inspired business models have resulted in a certain amount of disruption, the consequences of which often compromise the value of purpose-specific business assets in obsoleting or excess-capacity industries (e.g. coal in the face of growing energy alternatives and concerns for climate change). Assets that have productive capacity are typically sold in an orderly market and may achieve a value commensurate with the capital asset expenditures expectations of industry market participants. Real property assets and operating assets that can be successfully transitioned or re-purposed are often liquidated in an orderly fashion to maximize value. Specialized assets and/or assets with inferior productive capacity or which are positioned in unfavorable circumstances likely lack the ability to attract buyers due to the deficiencies and/or inefficiencies of relevant markets. Accordingly, the time value of money and the demands of the most senior creditors may suggest or dictate that a forced liquidation sooner is more favorable than a deferred outcome.
Most restructuring and bankruptcies involve a total rationalization of operating assets and business resources. For large integrated businesses, it often occurs that a combination of value premises applies to differing types of tangible and intangible assets based on the go-forward strategy of the business and the availability of markets in which to monetize assets. For example, an initial liquidation may occur with respect to certain business operations and properties to create the resources necessary to achieve debt restructuring or DIP financing. Accordingly, advisory engagements often take into consideration a wide range of options based on the timing of asset sales and the sustainability of continuing operations. The Premise of Value is a quiet but critical defining element for assessing the collective value proposition associated with a plan of reorganization.
Many bankruptcy advisory projects necessarily involve comparing the Going Concern value to Liquidation value. Each premise involves an inherently speculative set of underlying models and assumptions about the performance of the business and/or the timing and exit value achieved for business assets. And, each may be developed using a variety of scenarios with differing outcomes and event timing. Setting aside the qualitative aspects of decision making, the Premise of Value with the best outcome is typically the path of pursuit based on the necessity for an objective criterion required under the legalities of the bankruptcy process and the priority claims of creditors.
A fundamental understanding of the defining elements of value is critical to distressed businesses and their creditors. Valuation advisors are required to clearly detail the defining elements of value employed in the determination of asset values and enterprise valuations. The Premise of Value must be comprehended in the context of other defining elements of value. If you have a question concerning the design and valuation of varying plans of reorganization or bankruptcy strategies, please contact Mercer Capital’s Transaction Advisory Group.
U.S. M&A activity slowed sharply in the second quarter due to the economic shock resulting from the COVID-19 pandemic. Activity – especially involving lower-to-middle market businesses – is expected to remain muted for the duration of 2020 and throughout 2021 unless more effective therapeutics and/or vaccines are developed that facilitate a more bullish sentiment than currently prevails.
Although evidence is currently obscure, M&A markets appear to reflect wider bid-ask spreads among would-be sellers and buyers. Sellers are too fixated on what their business might have transacted for in 2019 while buyers expect to pay less as a result of declining performance and higher uncertainty regarding the magnitude and duration of the current economic malaise.
Numerous industries lack sufficiently motivated strategic buyers willing to overlook concerns for their existing businesses to say nothing of the integration of new business. On the other hand, certain financial buyers seem to have returned to the market looking to deploy capital at attractive valuations when and where acquisition financing is available at reasonable terms and pricing.
Would-be sellers face a dilemma: sell now for a seemingly compromised valuation; or wait for a recovery in market appetite that is not guaranteed to occur in the foreseeable future. Sellers are also faced with weighing the potential dilution of their future transaction proceeds if political regime/legislative change threatens the currently favorable tax environment. A modest consolation in the near-term for certain sellers may extend from the forgiveness of PPP loans under the CARES Act. As an aside from the current topical focus, sellers are advised to study the requirements and documentation for PPP forgiveness under change of control transaction events.
We believe that in the current environment, contingent payments (e.g., earnouts and/or clawbacks) and seller financing will be employed to a greater extent than in the past in order to bridge a widening bid ask gap in deal value. Contingent deal consideration is typically structured such that a portion of transaction consideration is contingent upon the buyer’s achievement of specified post-transaction performance thresholds. The current environment requires careful seller scrutiny of such terms.
When reasonably structured and negotiated, contingent consideration results in a symmetrical risk for buyers and sellers. While the economics can vary, earnouts often provide an incremental tranche of deal value that reconciles to that debated 0.5x to perhaps 2.0x turn that comprises the typical bid-ask spread (usually EBITDA based). For the buyer, contingent consideration acts as an insurance policy to insulate against downside future performance. For the seller contingent consideration can deliver deal consideration over and above that at the closing table, thus facilitating upfront liquidity while allowing for potential upside versus a straight all-cash closing. Sellers are advised to be careful about their unwillingness to entertain contingent consideration in the current environment because doing so can be a signal to the buyer of the seller’s concerns about near-term performance (i.e., actions speak louder than words). As always, every transaction is unique, requiring careful assessment of contingent consideration for purposes of productive negotiation.
In theory, sellers may have to provide more financing in the post-COVID environment in order to achieve acceptable terms and pricing. We use the qualifier “in theory” because the high yield and leverage loan markets that are an important source of acquisition financing improved sharply as the third quarter progressed with more capital being raised at tighter spreads than the second quarter.
An additional concern that has slowed M&A activity is execution. Conducting due diligence during a pandemic is inherently difficult and fraught with its own complications. It is easy to imagine how due diligence would have ground to a complete halt in an era before electronic data rooms and Zoom Video meetings. Nonetheless, travel prohibitions and social distancing protocols have stymied due diligence as most buyers require site visits and face-to-face meetings in order to consummate a purchase agreement. However, issuing a non-binding LOI remains quite doable, and some buyers are eager to secure the optionally and potential exclusivity obtained by an LOI submission.
M&A in most industries is pro-cyclical. Challenges notwithstanding, M&A activity should gradually improve if the economy continues to do so and as buyers and sellers adjust expectations to the current environment and business earnings “normalize” in 2021 or 2022.
The revised and updated third edition of Business Valuation: An Integrated Theory explores the core concepts of the integrated theory of business valuation and adapts the theory to reflect how the market for private business actually works.
In this third edition of their book, the authors, two experts on the topic of business valuation, help readers translate valuation theory into everyday valuation practice. This important updated book:
The third edition of Business Valuation is the only book available regarding an integrated theory of business valuation, offering an essential, unprecedented resource for business professionals.
Mercer and Harms’ Business Valuation: An Integrated Theory, Third Edition provides valuation professionals, attorneys, other users of valuations, and students of valuation a resource for better understanding how the pieces of the valuation puzzle fit together. This book is written in an easy to follow style and is worthy of being added to your valuation library.
Roger J. Grabowski, FASA
Managing Director, Duff & Phelps
It has been 13 years since the second edition of this book came out. It was certainly worth the wait. All the core chapters have been updated with easy-to-understand explanations of valuation concepts. Mercer and Harms have also added new chapters on the Income Approach (Cash Flows), the Income Approach (Discount Rate), the Market Approach (Guideline Public Companies), the Market Approach (Guideline Transactions), and Restricted Stock Discounts and Pre-IPO studies. This well-written book presents a thoughtful approach to business valuation. The bottom line is that this is a valuable resource that tackles controversial topics head on.
James R. Hitchner, CPA/ABV/CFF, ASA
Managing Director, Financial Valuation Advisors
Download the slide deck here.
In this September 23, 2020 webinar, Matt Crow and Taryn Burgess explain valuation considerations for independent trust companies and why common rules of thumb don’t always work.
During this time when the outlook for global markets, the economy, and one’s own health is uncertain, many trust company principals are working to nail down the unknowns associated with business ownership. Owners of independent trust cos are devoting more time to working on their buy-sell agreements in an effort to protect the working relationships with their partners and ensure they and their families are protected financially. While so much else is uncertain, the value of your independent trust company does not have to be.
This webinar is tailored to owners and principals of independent trust companies, but many of the topics are relevant for owners of all investment management firms.
The trucking industry has recently been shaken by a series of large accident-related litigation verdicts, also known as nuclear verdicts. The definition of what constitutes a nuclear verdict can vary; however, the most common definition is verdicts in excess of $10 million. No matter how they are defined, nuclear verdicts are causing upheaval in the trucking industry. Trucking companies have historically only had to insure drivers for $1 million each, amplifying the effect of significantly larger verdicts.
The American Transportation Research Institute (ATRI) conducted an analysis of over 400 cases from 2006 through 2019. ATRI issued its findings in its June 2020 publication “Understanding the Impact of Nuclear Verdicts on the Trucking Industry.” The table below summarizes the data analyzed by ATRI. While the majority of verdicts still fall under $2 million, the number of large verdicts has increased, and the size of those large verdicts has continued to grow.
According to ATRI’s analysis, nuclear verdicts have increased at a much faster rate than can be accounted for by inflation or increase in health care costs. The chart below (from ATRI’s June 2020 publication) shows the rapid increase in verdict size.
It is not a surprise that trucking companies are already responding to these verdicts. Many companies are beefing up safety measures, including installing in-cab cameras to watch drivers and keep an extra eye on the road. Others are conducting more thorough reviews of drivers and are paying closer attention to prior incidents.
Some of the biggest impact can be seen in insurance premiums in the industry. The average insurance premium increased 42% from 2010 to 2018, and several major underwriters have exited the trucking industry altogether. Premiums are only expected to go higher – possibly increasing as much as 20% or 30% in 2020. Higher premiums have changed the way some companies conduct business. Rather than operate their fleets directly, some carriers have leased their trailers to a larger firm, hoping to take advantage of the larger company’s insurance policy.
Overall, the increase in nuclear verdicts fuels uncertainty in the trucking industry, making it difficult for trucking companies to budget insurance and litigation expenses.
Originally published in the Value Focus: Transportation & Logistics, Second Quarter 2020.
Mercer Capital is a national valuation and financial/transaction advisory firm. The Neiman Marcus Chapter 11 bankruptcy filing raises multiple valuation questions:
Neiman Marcus Group, Inc. (“Neiman Marcus” or “Company”) is a Dallas, Texas-based holding company that operates four retail brands: Neiman Marcus, Bergdorf Goodman, Last Call (clearance centers), and Horchow (home furnishings). Unlike other department store chains, such as JCPenney and Macys that cater to the mass market, Neiman Marcus’s target market is the top 2% of U.S. earners.
Among the notable developments over the last 15 years were two private equity transactions that burdened the Company with a significant debt load and one well-timed acquisition. The debt and acquisition figured prominently in the May 7, 2020 bankruptcy filing in which the company sought to reorganize under Chapter 11 with the backing of most creditors.
The iconic Neiman Marcus department store was established in 1907 in Dallas. Over the ensuing decades, the Company prospered as oil wealth in Texas fueled demand for luxury goods. Neiman Marcus merged with Broadway-Hale Stores (later rechristened Carter Hawley Hale Stores, Inc.) in the late 1960s. Additional stores were opened outside of Texas in Atlanta, South Florida, and other wealthy enclaves around the U.S. except for New York where Bergdorf Goodman (acquired in the 1970s) operated two stores.
In 1987, Neiman Marcus along with Bergdorf Goodman was partially spun out as a public company with the remaining shares spun in 1999.
In 2005, the Company was acquired via a $5 billion LBO that was engineered by Texas Pacific Group and Warburg Pincus. Once the economy rebounded sufficiently from the Great Financial Crisis, the PE-owners reportedly sought to exit via an IPO in 2013. However, the IPO never occurred. Instead, the Company was acquired for $6 billion by Ares Management and the Canada Pension Plan Investment Board (“CPPIB”).
In 2014 Neiman Marcus acquired MyTheresa, a German luxury e-commerce retailer with annual revenues of $130 million, for $182 million of cash consideration. During 2018, the entity that held the shares of MyTheresa (MyT Holding Co.) was transferred via a series of dividends to the Neiman Marcus holding company directly controlled by Ares and CPPIB and thereby placed the interest out of the reach of Company creditors.
Neiman Marcus filed an S-1 in 2015 in anticipation of becoming a public company again; however, the registration statement was withdrawn due to weak investor demand.
Although Neiman Marcus’ common shares had not been publicly traded since 2005, the Company filed with the SEC because its debt was registered. During June 2019, the Company deregistered upon an exchange of new notes and preferred equity for the registered notes. S&P described the restructuring as a selective default because debt investors received less than promised with the original securities.
Figure 1 below presents a recent summary of the company’s financial performance and position one year prior to the bankruptcy filing. Of note is the extremely high debt burden that equated to 12.4x earnings before interest taxes, depreciation, and amortization (“EBITDA”) for the last twelve months (“LTM”) ended April 27, 2019. Although definitions vary by industry, federal banking regulators consider a company to be “highly levered” if debt exceeds EBITDA by 6x.
Moody’s downgraded the Company’s corporate credit rating to B3 from B2 in October 2013 with the acquisition by Ares and CPPIB. Moody’s also established an initial rating of Caa2 for unsecured notes issued to partially finance the acquisition. By the time the notes were deregistered, Moody’s had reduced the corporate rating to Caa3 and the notes to Ca.
Moody’s defines Caa as obligations that “are judged to be of poor standing and are subject to very high credit risk,” and Ca as obligations that are “highly speculative and are likely in, or very near, default, with some prospect of recovery in principal and interest.”
Neiman Marcus has struggled with a high debt load since the first LBO in 2005, which has been magnified by the disruptive impact that online retailing has had on department stores. EBITDA declined from $665 million in FY2015 to $400 million in the LTM period ended April 27, 2019; the EBITDA margin declined by over a third from 13.1% to 8.5%, over the same time. By April 2019, debt equated to 12.4x LTM EBITDA and covered interest expense by 1.2x.
By way of reference, the debt/EBITDA and EBITDA/interest ratios for Ralph Lauren (NYSE: RL) for the fiscal year ended March 30, 2019, were 1.0x and 47.1x, while the respective ratios for Dillard’s (NYSE: DDS) were 1.2x and 9.9x for the fiscal year ended February 2, 2019.
At the time of bankruptcy, Neiman Marcus generated about one-third of its sales (about $1.5 billion) online. MyTheresa generated approximately $500 million of this up from $238 million in 1Q17 when certain subsidiaries that held MyTheresa were designated “unrestricted subsidiaries” by the Company. While MyTheresa’s sales increased, the legacy department store business declined as the Company struggled to connect with younger affluent customers who favored online start-up boutiques and had little inclination to shop in a department store.
As shown in the chart below, ecommerce sales as a portion of total retail sales have doubled over the last five years to about 12% in 2019. The move to work from home (“WFH”) and social distancing practices born of COVID-19 in early 2020 have accelerated the trend such that the pre-COVID-19 projection of e-commerce sales rising to 15% by 2020 will likely prove to be significantly conservative.
Neiman Marcus filed on May 7, 2020 for chapter 11 bankruptcy protection. The COVID-19 induced shutdown of the economy was the final nail in the coffin, which forced major furloughs and the closing of its stores in accordance with various local shelter-in-place regulations. Other recent retail bankruptcies include Lord & Taylor, Men’s Warehouse, Ann Taylor, Brooks Brothers, Lucky Brands, J. Crew with many more expected to file.
The initial plan called for creditors to convert $4 billion of $5 billion of debt into equity. The plan does not provide for mass store closures or asset sales, although the Last Call clearance stores will close.
As noted, the bankruptcy filing follows a restructuring in June 2019 that entailed:
The restructuring did not (apparently) materially impact the Company’s $900 million asset-based credit facility of which $455 million was drawn as of April 2019; or the first lien $125 million debentures due in 2028.
As shown in Figure 4, market participants assigned little value to the $1.2 billion of third lien notes that were trading for around 8% of par when the bankruptcy filing occurred and 6% of par in late August 2020.
The binding Restructuring Support Agreement (“RSA”), dated May 7, 2020, included commitments from holders of 99% of the Company’s term loans, 100% of the second line notes, 70% of the third line notes, and 78% of the residual unsecured debentures to equitize their debt. Also, certain creditors agreed to backstop $675 million in debtor-in-possession (“DIP”) financing and to provide $750 million of exit financing which would be used to refinance the DIP facility and provide incremental liquidity.
DIP financing is often critical to maintain operations during the bankruptcy process when the company has little cash on hand. DIP financing is typically secured by the assets of the company and can rank above the payment rights of existing secured lenders. DIPs often take the form of an asset-based loan, where the amount a company borrows is based on the liquidation value of the inventory, assuring that if the company is unable to restructure, the loan can be repaid from the liquidation of the retailer’s assets.
Federal law governs the bankruptcy process. Broadly, a company will either reorganize under Chapter 11 or liquidate under Chapter 7.
A Chapter 7 filing typically is made when a business has an exceedingly large debt combined with underlying operations that have deteriorated such that a reorganized business has little value. Under Chapter 7, the company stops all operations. A U.S. bankruptcy court will appoint a trustee to oversee the liquidation of assets with the proceeds used to pay creditors after legal and administrative costs are covered. Unresolved debts are then “discharged”, and the corporate entity is dissolved.
Under Chapter 11, the business continues to operate, often with the same management and board who will exert some control over the process as “debtor in possession” operators. Once a Chapter 11 filing occurs, the debtor must obtain approval from the bankruptcy court for most decisions related to asset sales, financings, and the like.
Most public companies and substantive private ones such as Neiman Marcus file under Chapter 11. If successful, the company emerges with a manageable debt load and new owners. If unsuccessful, then creditors will move to have the petition dismissed or convert to Chapter 7 to liquidate.
Most Chapter 11 filings are voluntary, but sometimes creditors can force an involuntary filing. Normally, a debtor has four months after filing to propose a reorganization plan. Once the exclusivity period ends creditors can propose a competing plan.
Usually, the debtor continues to operate the business; however, sometimes the bankruptcy court will appoint a trustee to oversee the business if the court finds cause to do so related to fraud, perceived mismanagement and other forms of malfeasance.
The U.S. Trustee, the bankruptcy arm of the Justice Department, will appoint one or more committees to represent the interests of the creditors and stockholders in working with the company to develop a plan of reorganization. The trustee usually appoints the following:
Once an agreement is reached it must be confirmed by the court in accordance with the Bankruptcy Code before it can be implemented. Even if creditors (and sometimes stockholders) vote to reject the plan, the court can disregard the vote and confirm the plan if it believes the parties are treated fairly.
Neiman Marcus pursued a “prepackaged” or “prepack” Chapter 11 in which the company obtained support of over two-thirds of its creditors to reorganize before filing. Under the plan, the Company would eliminate about $4 billion of $5.5 billion of debt. The creditors also committed a $675 million DIP facility that will be replaced with a $750 million facility once the plan is confirmed by the court.
Valuation issues are interwound in bankruptcy proceedings, especially in Chapter 11 filings when a company seeks to reorganize. Creditors and the debtor will hire legal and financial advisors to develop a reorganization plan that maximizes value and produces a reorganized company that has a reasonable likelihood of producing sufficient cash flows to cover its obligations.
There are typically three valuation considerations for companies restructuring through Chapter 11 Bankruptcy.
Sometimes as is the case with Neiman Marcus there is a fourth valuation-related issue that deals with certain transactions that may render a company insolvent.
A side story to Neiman Marcus relates to the 2018 transaction in which the shares of MyTheresa were transferred in 2018 to bankruptcy-remote affiliates of PE owners Ares and CPPIB. Under U.S. bankruptcy law, transferring assets from an insolvent company is a fraudulent transaction.
During 2017, Neiman Marcus publicly declared the subsidiaries that held the shares were “unrestricted subsidiaries.” Once the distribution occurred in September 2018, creditors litigated the transaction. All but one (Marble Ridge) settled in 2019 as part of the previously described debt restructuring.
Since the bankruptcy filing occurred, the unsecured creditors commissioned a valuation expert to review the transaction to determine whether Neiman Marcus was solvent as of the declaration date, immediately prior to the distribution and after the distribution. As shown in Figure 5, the creditors’ expert derived a negative equity value on all dates. If the court accepted the position, then presumably Ares and CPPIB would be liable for fraudulent conveyance.
At the time the distribution occurred, Neiman Marcus put forth an enterprise valuation of $7 billion and relied upon the opinion of two national law firms that it was within its rights to execute the transaction. Since filing, the PE owners have commissioned one or more valuation experts whose opinion has not been disclosed.
On July 31, 2020, the committee of unsecured creditors and the Company reached a settlement related to the fraudulent conveyance claims arising from the MyTheresa transaction. Ares and CPPIB agreed to contribute 140 million MyTheresa Series B preferred shares, which represent 56% of the B class shares, to a trust for the benefit of the unsecured creditors. The Company also agreed to contribute $10 million cash to the trust. A range of value for the series B shares of $0 to $275 million was assigned in a revised disclosure statement filed with the bankruptcy court.
Marble Ridge, which served on the committee, did not view the settlement as sufficient as was the case in 2019 when it did not participate in the note exchange as part of the 2018 litigation settlement.
During August, it became known that Marble Ridge founder Dan Kamensky pressured investment bank Jeffrey’s not to make a bid for the shares that were to be placed in a trust because it planned to bid, too (reportedly 20 cents per share compared to 30 cents or higher by Jeffrey’s). The anti-competitive action was alleged to have cost creditors upwards of $50 million. Marble Ridge subsequently resigned from the creditors committee and announced plans to close the fund. Kamensky was arrested on September 7th and charged with securities fraud, extortion, wire fraud, extortion, and obstruction of justice, according to the U.S. Attorney’s Office for the Southern District of New York.
A best interest test must show that the reorganization value is higher than the liquidation value of the company, to ensure that the creditors in Chapter 11 receive at least as much under the restructuring plan as they would in a Chapter 7 liquidation.
In the case of Neiman Marcus, the liquidation vs. reorganization valuation analysis was a formality because most unsecured creditors and the Company agreed to a prepackaged plan subject to resolution of such items as the MyTheresa shares. Nonetheless, we summarize both for illustration purposes.
A rough calculation of Neiman Marcus’ liquidation value is included below, based on balance sheet data from April 2019 as these are the most current figures available.
Substantial value in a liquidation analysis depends upon what an investor would be willing to pay for the rights to the Neiman Marcus name as well as its customer lists and proprietary IP code. The recovery ratio applied to Neiman Marcus’ inventory is higher than expected recovery ratios across the broader apparel industry since much of Neiman’s inventory is designer goods. Nonetheless, the analysis implies creditors would face a significant haircut in a Chapter 7 liquidation scenario.
The reorganization value represents the value of the company once it has emerged as a going concern from Chapter 11 bankruptcy. Typically, the analysis will develop a range of value based upon (i) Discounted Cash Flow (“DCF”) Method; (ii) Guideline Public Company Method; and (iii) Guideline Transaction Method.
Both guideline methods develop public company and M&A “comps” to derive representative multiples to apply to the subject company’s earnings and cash flow. Market participants tend to focus on enterprise value (market value of equity and debt net of cash) in relation to EBITDA. Secondary multiples include enterprise value in relation to EBIT, EBIT less ongoing Capex, and revenues.
As it relates to Neiman Marcus, we note that Lazard Freres & Co. (“Lazard”) as financial advisor focused on adjusted EBITDA for the LTM period ended February 1, 2020 and the projected 12 months ended February 1, 2022. In doing so, Lazard looked past 2020 and 2021 as excessively abnormal years due to the COVID19 induced recession. Our observation is that this treatment (for now) is largely consistent with how many market participants are treating various earning power measures in industries that were severely impacted by the downturn.
A DCF analysis for Neiman Marcus that assumes the Company emerges from bankruptcy in the fall of 2020 will incorporate the impact of the adverse economy as reflected in presumably subpar operating performance in the first year or two of the projections. More generally, the DCF method involves three key inputs: the forecast of expected future cash flows, terminal value, and discount rate.
The sum of the present values of all forecasted cash flows indicates the enterprise value of the emerging company for a set of forecast assumptions. Reorganization value is the total sum of expected business enterprise value and proceeds from the sale or disposal of assets during the reorganization.
The second valuation hurdle Neiman Marcus will have to jump is a cash flow test. The cash flow test determines the feasibility of the reorganization plan and the solvency of future operations. Since a discounted cash flow analysis is typically used to determine reorganization value, the projected cash flows from this analysis are compared to future interest and principal payments due.
Additionally, the cash flow test details the impact of cash flows on the balance sheet of the restructured entity, entailing modeling changes in the asset base and in the debt obligations of and equity interests in the company. Therefore, the DCF valuation and cash flow tests go together because the amount of debt that is converted to equity creates cash flow capacity to service the remaining debt. If the cash flow model suggests solvent operations for the foreseeable future, the reorganization plan is typically considered viable.
When emerging from bankruptcy in the case of going concern, fresh-start accounting could be required to allot a portion of the reorganization value to specific intangible assets. The fair value measurement of these assets requires the use of multi-period excess earnings method or other techniques of purchase price allocations.
Neiman Marcus plans to eliminate about $4 billion of over $5 billion of debt and $200 million of annual interest expense in a reorganization plan that was approved by U.S. bankruptcy judge David Jones in early September. The plan will transfer the bulk of ownership to the first lien creditors, including PIMCO, Davidson Kempner Capital Management and Sixth Street Partners. PIMCO will be the largest shareholder with three of seven board seats.
Other creditors will receive, in effect, a few pennies to upwards of one-third of what they were owed depending in part on the value of MyTheresa Class B preferred shares that were contributed to a trust for the benefit of unsecured creditors. Also, the Company’s term loan lenders, second lien and third lien note holders waived their right to assert deficiency claims and thereby eliminated upwards of $3.3 billion of additional claims in the general unsecured claims pool (now limited to $340 to $435 million).
Lazard estimated the value of the reorganized Company upon exit from bankruptcy to approximate $2.0 billion to $2.5 billion on an enterprise basis with the equity valued at $800 million to $1.3 billion.
Creditors and the Company negotiated a plan that has presumably maximized (or nearly so) value to each creditor class based upon the priority of their claims. We are not privy to the analysis each class produced and how their views of the analyses, relative negotiating strength and the like drove the settlement.
Ultimately, the performance of the reorganized Neiman Marcus will determine the eventual amount recovered by creditors to the extent shares are not sold immediately. Some creditors would be expected to sell the shares immediately, while others who have flexibility to hold equity interests and have a favorable view of the reorganized company’s prospects may wait to potentially realize a greater recovery.
In Figure 9 we have constructed a waterfall analysis which we compare with the actual settlement. We assume a range of enterprise values based upon multiples of projected FY22 EBITDA, or $342 million, and compare the residual equity after each claimant class is settled to provide perspective on the creditors’ recovery.
This waterfall implies that class 5 through 7 debt, which for our purposes here is more or less pari passu, should receive the bulk if not all of the equity given $2.4 billion of debt owed to the three classes. Because ~10% of the equity was allocated to subordinated creditors, the senior lenders may have been willing to cede some ownership in order to reach a settlement more quickly.
Per the settlement, ~90% of the equity was allocated to the 2019 senior secured term loan (~$2.3 billion; 87.5%), 2013 residual senior secured loan ($13 million) and first lien debentures ($129 million; 2.8%).
Recovery for the 2019 senior secured creditors was estimated in the Disclosure Statement to approximate 33% compared to about 19% for the first lien debentures.
Interests in MyTheresa also impacted projected recoveries for the junior and unsecured creditors, a byproduct of the litigation to settle the fraudulent conveyance claims related to the 2018 transaction.
The second lien noteholders ($606 million) would obtain (i) 1.0% equity interest; (ii) seven-year warrants to purchase up to 25% of the reorganized equity at an agreed upon strike price; (iii) participation rights in the exit loan and associated fees; and (iv) an economic interest in MyTheresa in the form of $200 million of 7.5% PIK notes.
The disclosure statement indicates the recovery equates to less than 2% of what is owed to the second lien note holders, which appears to exclude whatever value is attributable to the PIK notes because 1% of the Newco equity would equate to $800 thousand to $1.3 million of value based upon a range of equity value of $800 million to $1.3 billion.1
The third lien noteholders ($1.3 billion) would obtain (i) 8.5% equity interest; (ii) participation rights in the exit loan and associated fees; and (iii) a 50% economic and 49.9% voting interest in the common equity of MyTheresa.
The disclosure statement indicates the recovery to be 5.6% of the claim, which also appears to exclude the value of the MyTheresa common shares if the equity interest is equal to $68 million to $110 million based upon an aggregate equity value of $800 million to $1.3 billion.
The issuance of $200 million of PIK notes and transfer of 50% of the common equity interest in MyTheresa to the second and third lien noteholders appears to be a result of the 2019 debt restructuring and settlement of the 2018 litigation surrounding the 2018 transfer of MyTheresa to the parent company and out of the reach of creditors.
The final wrinkle in the disputed MyTheresa saga involved an agreement reached in late July 2020 in which Ares and CPPIB agreed to allocate 140 million (56%) MyTheresa Series B preferred shares to a trust established for unsecured creditors. Neiman Marcus as debtor also agreed to contribute $10 million cash to the trust.
At the time the settlement was announced in late July, the value attributed to the preferred shares was $162 million; however, the August 3 Disclosure Statement assigned a range of value of $0 to $275 million. Marble Ridge reportedly had planned to bid 20 cents per share to provide certain unsecured creditors (e.g. unpaid vendors) immediate liquidity before the fracas with Jeffrey’s occurred.
Neiman Marcus emerged from Chapter 11 by September 30, 2020 in a streamlined process via the prepackaged negotiations that will leave the Company with significantly less debt in its capital structure. As outlined in this article, valuation is an important factor in the bankruptcy process.
1 The issuance of $200 million of PIK notes and transfer of 50% of the common equity interest in MyTheresa to the second and third lien noteholders appears to be a result of the 2019 debt restructuring and settlement of the 2018 litigation surrounding the 2018 transfer of MyTheresa to the parent company and out of the reach of creditors.
2 The projected 1.4% recovery rate for the second lien notes apparently excludes the MyTheresa PIK notes, while the projected 5.6% recovery rate for the third lien notes likewise appears to exclude the 50% common equity interest in MyTheresa.
Business appraisers refer to different kinds of values for businesses and business interests in terms of “levels of value.” Since value is a function of expected cash flows, risk and growth, the different levels of value are defined by these factors as they relate to each level. Beginning in 1990, a three-level chart reflected the manner in which most appraisers looked at the value of businesses and interests in them. Currently, most appraisers think in terms of four levels of value, and these charts provide a conceptual overview of these levels. Business appraisers use certain valuation “premiums” and “discounts” to describe movement between the levels on the chart. The first four charts refer to the value of equity of businesses. The last chart translates the levels of value in terms of enterprise (total capital) value. The charts are taken or derived from Business Valuation: An Integrated Theory Third Edition by Z. Christopher Mercer, FASA, CFA, ABAR, and Travis W. Harms, CFA, CPA/ABV.
If you have questions pertaining to the valuation of businesses or business interests, feel free to call us to discuss in confidence. Given our work-from-home business model during the COVID-19 pandemic, call our main number at 901-685-2120 and you will be directed to an analyst who can help with your questions.
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The determination of the appropriate “standard of value” when performing business valuations and other valuation related analyses for bankruptcy purposes is critical. While a standard of value is often specified, it is frequently the case that the specific standard of value is not well defined in either the Bankruptcy Code, applicable state statutes, or in judicial guidance. Further, the standard of value terminology used in valuations for bankruptcy purposes often differs from the terminology used for other (non-bankruptcy) purposes.
Traditional business valuations (those for purposes other than bankruptcy) are typically performed using one of the three basic standards of value: (1): fair market value, (2): fair value, or (3): investment value. While some might argue that a fourth standard of value – intrinsic value – is available to business appraisers and should be included among the typical, standards of value, use of this standard of value is rarely mandated by valuation guidance, statues, or law. Furthermore, intrinsic value (also referred to as fundamental value) is not as well defined as the other standards of value, and while mentioned in certain case law, such references rarely provide a specific definition of the standard. As such, intrinsic value is not addressed in this article.
The most recognized and accepted standard of value in relation to business and securities valuation in the U.S. is fair market value. Fair market value applies to nearly all federal and state income and corporate tax matters and is either the specified legal standard or guidepost of value for many other valuation purposes. Additionally, alternative standards of value are also frequently equated to their functional equivalents under fair market value. Although multiple definitions of fair market value exist, they are quite consistent and functionally almost identical.
The definition established for fair market value in tax regulations by Treasury Regulation Section 20.2031-1(b) is as follows:
The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.
A second definition of fair market value is available from the International Glossary of Business Valuation Terms as:
[T]he price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.
Yet a third definition of fair market value is provided within Section 3(18) (B) of the Employee Retirement Income Security Act wherein adequate consideration in the case of an asset for which there is no generally recognized market (e.g., stock of a closely held corporation) is defined as the fair market value of the asset as determined in good faith by the trustee or named fiduciary pursuant to the terms of the plan and in accordance with the regulations promulgated by the Secretary of Labor. The term “fair market value” is defined in proposed section 2510.3-18(b) (2) (i) as follows:
The price at which an asset would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, and both parties are able, as well as willing, to trade and are well-informed about the asset and the market for that asset.
It is widely recognized that these definitions are in general agreement, particularly in regard to their common references to (i) willing buyers and sellers, (ii) lack of compulsion, and (iii) reasonable knowledge of relevant facts. While International Glossary of Business Valuation Terms definition includes reference to (i) the hypothetical nature of the parties to the exchange, (ii) the arm’s length nature of the exchange, and (iii) an open and unrestricted market, it is widely held that these differences in the definitions are immaterial in most situations. As such, while three commonly used definitions exist, fair market value is the most well and consistently understood of the standards of value.
The fair value standard of value is also commonly used by business appraisers. Unlike fair market value, however, fair value’s different definitions are intentionally fashioned for different purposes. Within one purpose (financial reporting), the application of fair value is quite consistent due to now well-established standards codifications issued by the Financial Accounting Standards Board (“FASB”). In the broader legal and financial environment, the definition and or application of fair value can vary significantly from one state to another.
Within the American Institute of Certified Public Accountants’ (AICPA) Statements on Standards for Valuation Services (SSVS), fair value is described as having two commonly used, albeit distinctly different definitions.
For financial reporting purposes, fair value is defined under the FASB’s Accounting Standards Codification (ASC) glossary as:
the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
This definition is further discussed in ASC 820 as the price being based upon a hypothetical transaction for the subject asset or liability at the measurement date, considered from the perspective of a market participant. According to ASC 820, a market participant is: (i) an unrelated party, (ii) knowledgeable of the subject asset or liability, (iii) able to transact, and (iv) motivated but not compelled to transact.
This standard of value and the definition for this standard of value is universally used for financial accounting purposes within the U.S. Although quite similar to the definitions for fair market value in many respects, the definition of fair value for financial reporting purposes has distinct differences from the definitions for fair market value – particularly in the application of the market participant perspective.
In many states, fair value is the standard of value applicable by statute in regard to cases involving dissenting shareholder rights and is frequently used state minority oppression cases. However, in these settings there may be no single definition or understanding of the fair value standard of value. Alternatively, or as an adjunct to ambiguous state statues, legal precedent may provide the primary guidance for defining fair value.
Investment value is much less commonly utilized by valuation practitioners than fair market value, or fair value. Unlike fair market value and fair value, investment value is rarely a required standard of value. It is most often used to support merger and acquisitions, or other business transaction related matters.
While there is more than one definition of investment value, they are generally considered to be materially similar in meaning, albeit in part due to the definitions’ intentional lack of specificity.
The International Glossary of Business Valuation Terms defines investment value as:
[T]he value to a particular investor based on individual investment requirements and expectations.
Note the intentional generalities and lack of constraints relative to the definitions of fair market value and the definition of fair value in regard to financial reporting matters.
Similarly, albeit somewhat longer, in real estate terminology investment value is defined as:
The specific value of an investment to a particular investor or class of investors based on individual investment requirement; distinguished from market value, which is impersonal and detached.
These two definitions of investment value are generally considered to be equivalent.
As with fair value, the legal terminology describing the applicable standard of value for bankruptcy is not clearly defined in the U. S. Bankruptcy Code, or in applicable state statutes. Unlike standards of value outside of bankruptcy, standards of value within bankruptcy are numerous, lacking in clarity, and inconsistent. Among the standards of value for bankruptcy purposes referenced in the Forensic & Valuation Services Practice Aid – Providing Bankruptcy and Reorganization Services, 2nd Edition Volume 2 — Valuation in Bankruptcy (F&VSPA) are:
The sources for these standards of value include the U.S. Bankruptcy Code, The Uniform Fraudulent Transfer Act (UFTA), and The Uniform Fraudulent Conveyance Act (UFCA). Guidance as to the definitions for these terms, or the application of the terms, are minimal, and often nonexistent, within the Code, the UFTA, or the UFCA. Guidance as available within the Code, the UFTA, or the UFCA is as follows:
Section 101(32) of the U.S. Bankruptcy Code defines insolvency as a:
…financial condition such that the sum of such entity’s debt is greater than all of such property, at a fair valuation…
Fair valuation in this context is generally interpreted by bankruptcy case law, albeit not specifically defined, as fair market value.
Within the UFTA, Section 2(a) indicates, “A debtor is insolvent if the sum of the debtor’s debts is greater than all of the debtor’s assets, at a fair valuation.” The UFTA provides no definition of fair valuation, however, fair valuation is frequently analyzed similarly to fair market value when evaluating solvency.
Section 548 of the U.S. Bankruptcy Code explains that a fraudulent transfer has occurred if a debtor has “received less than a reasonably equivalent value in exchange for such transfer or obligation.” No definition of reasonably equivalent value is provided, although the Code does define value to mean “property, or satisfaction or securing of a present or antecedent debt of the debtor, but does not include an unperformed promise to furnish support to the debtor or to a relative of the debtor.”
The F&VSPA indicates that the courts have historically considered fair market value exchanged when evaluating reasonably equivalent value. However, the U.S. Supreme Court has noted that, reasonably equivalent value is not always evaluated against a fair market value benchmark.
When evaluating whether a transfer was fraudulent to present and future creditors the UFTA considers whether “a reasonably equivalent value [was] exchange[d] for the transfer or obligation.” The fair market value of the assets or debt exchanged is commonly considered. However, as previously referenced in regard to the U.S. Supreme Court, reasonably equivalent value is not always evaluated against a fair market value benchmark.
The U.S. Bankruptcy Code mandates that a Chapter 11 plan must be fair and equitable to all holders of secured claims. In circumstances where the debtor’s reorganization plan is accepted over the objections of a secured creditor, the court must ensure the plan provides that secured creditors receive the indubitable equivalent of their respective claims.
Section 2(1) of the UFCA includes a reference to the present fair saleable value of assets in considering insolvency. Some jurisdictions have interpreted present fair saleable value to be similar to fair market value, although other jurisdictions have taken a position whereby the present fair saleable value standard imposes a reduced marketing period.
UFCA’s Section 3 indicates that fair consideration is given for property or an obligation
Therefore, fair consideration is characterized as a good faith transfer whereby the debtor receives reasonably equivalent value. The fair market values exchanged are commonly used when evaluating fair consideration in states that have adopted the UFCA, as they are under the Bankruptcy Code.
There is simply no clear standard of value that can be universally relied upon in the context of bankruptcy proceedings. Standard of value terminology, definitions, and guidance within the bankruptcy realm are significantly lacking in comparison to that available to business appraisers engaged in tax and financial reporting related matters. In the absence of clear standard of value definitions and guidance, precedent must often be relied upon. It is therefore crucial in bankruptcy endeavors that a business appraiser have knowledge of these standard of value considerations and work closely with experienced bankruptcy attorneys in order to apply the correct standard of value to best serve their client.
 Valuing a Business, 5th edition (Pratt, Reilly, Schweihs), p. 45
 The Appraisal of Real Estate, 11th edition (Chicago Appraisal Institute, 1996), p. 638.
 Forensic & Valuation Services Practice Aid – Providing Bankruptcy and Reorganization Services, 2nd Edition Volume 2 — Valuation in Bankruptcy
 See Andrew Johnson Properties, Inc., CCD Dec. ¶ 65, 254 (D.C. Tenn. 1974); Briden v. Foley, 776 F.2d 379, 382 (1st Cir. 1985)
 Barber v. Golden Seed Co., 129 F.3d 382, 387 (7th Cir. 1997)
 BFP v. Resolution Trust Corp., 511 U.S. 531, 548 (1994).
 UFTA Sections 4(a)(2) and 5(a).
 BFP v. Resolution Trust Corp., 511 U.S. 531, 548 (1994).
 USC 1129(b)(2)(A).
 HBE Leasing Corp. v. Frank, 48 F.3d 623, 633 (2d Cir. 1994).
In our last update regarding core deposit trends published in October 2019, we described a decreasing trend in core deposit intangible asset values in light of falling interest rates. As a result, the interest-rate environment was not positive for core deposit valuations before COVID. Less than six months later, the World Health Organization declared the coronavirus outbreak a pandemic, and the world changed drastically. In response, the Fed cut rates to effectively zero, and the yield on the benchmark 10-year Treasury reached a record low. While many factors are pertinent to analyzing a deposit base, a significant driver of value is market interest rates. In a world of cut-rate alternative wholesale funding, core deposits have lost some of their luster.
As shown in Figure 2, only ten whole-bank transactions were announced in the second quarter of 2020, representing the fewest deals announced during a quarter over the time period analyzed. For comparison, the first quarter of 2009 posted the second lowest figure with 19 announced deals. It seems unlikely that deal activity will fully recover in the near future. There are several issues hindering deal activity:
On the other hand, there are a couple of factors that might cause some banks to resume M&A discussions more quickly.
Using data compiled by S&P Global Market Intelligence, we analyzed trends in core deposit intangible (CDI) assets recorded in whole bank acquisitions completed from 2000 through June 30, 2020. CDI values represent the value of the depository customer relationships obtained in a bank acquisition. CDI values are driven by many factors, including the “stickiness” of a customer base, the types of deposit
accounts assumed, and the cost of the acquired deposit base compared to alternative sources of funding. For our analysis of industry trends in CDI values, we relied on S&P Global Market Intelligence’s definition of core deposits.1 In analyzing core deposit intangible assets for individual acquisitions, however, a more detailed analysis of the deposit base would consider the relative stability of various account types. In general, CDI assets derive most of their value from lower-cost demand deposit accounts, while often significantly less (if not zero) value is ascribed to more rate-sensitive time deposits and public funds, or to non-retail funding sources such as listing service or brokered deposits which are excluded from core deposits when determining the value of a CDI.
Figure 3 summarizes the trend in CDI values since the start of the 2008 recession, compared with rates on 5-year FHLB advances. Over the post-recession period, CDI values have largely followed the general trend in interest rates—as alternative funding became more costly in 2017 and 2018, CDI values generally ticked up as well, relative to post-recession average levels. Throughout 2019, CDI values exhibited a declining trend in light of yield curve inversion and Fed cuts to the target federal funds rate during the back half of 2019. This trend was exacerbated in March 2020 when rates were effectively cut to zero.
The average CDI value declined 110 basis points from June 2019 to June 2020 while the five-year FHLB advance declined 157 basis points over the same period. The decline in CDI values has been somewhat slower than the drop in benchmark interest rates, in part, because deposit costs typically lag broader movements in market interest rates. For example, the average money market deposit rate and the average one-year CD rate declined 14 basis points and 43 basis points, respectively, over the same one-year period. In general, banks were slow to raise deposit rates in the period of contractionary monetary policy through 2018 and, as a result, rates remain below benchmark levels leaving banks less room to reduce rates further. For CDs, the lagging trend is even more pronounced. Now that rates are on the decline, banks have been stuck with CDs that cannot be repriced until their maturities even as benchmark rates fall. While time deposits typically are not considered “core deposits” in an acquisition and thus would not directly influence CDI values, they do significantly influence a bank’s overall cost of funds.
Average CDI values have fallen for the past six consecutive quarters. Since early 2008 CDI values have averaged 1.45% of deposits, meaningfully lower than long-term historical levels which averaged closer to 2.5-3.0% in the early 2000s.
Core deposit intangible assets are related to, but not identical to, deposit premiums paid in acquisitions. While CDI assets are an intangible asset recorded in acquisitions to capture the value of the customer relationships the deposits represent, deposit premiums paid are a function of the purchase price of an acquisition. Deposit premiums in whole bank acquisitions are computed based on the excess of the purchase price over the target’s tangible book value, as a percentage of the core deposit base. While deposit premiums often capture the value to the acquirer assuming the established funding source of the core deposit base (that is, the value of the deposit franchise), the purchase price also reflects factors unrelated to the deposit base, such as the quality of the acquired loan portfolio, unique synergy opportunities anticipated by the acquirer, etc. Additional factors may influence the purchase price to an extent that the calculated deposit premium doesn’t necessarily bear a strong relationship to the value of the core deposit base to the acquirer. This influence is often less relevant in branch transactions where the deposit base is the primary driver of the transaction and the relationship between the purchase price and the deposit base is more direct. Figure 4 presents deposit premiums paid in whole bank acquisitions as compared to premiums paid in branch transactions.
As shown in Figure 5, deposit premiums paid in whole bank acquisitions have shown more volatility than CDI values. Despite improved deal values prior to the second half of 2019, deposit premiums in the range of 7% to 10% remain well below the pre-Great Recession levels when premiums for whole bank acquisitions averaged closer to 20%.
Deposit premiums paid in branch transactions have generally been less volatile than tangible book value premiums paid in whole bank acquisitions. Branch transaction deposit premiums averaged in the 4.5%-7.5% range during 2019, up from the 2.0-4.0% range observed in the financial crisis. Only five branch transactions were completed in the first half of 2020, but the range of their implied premiums is in line with 2019 levels. There have been several branch transactions announced since the onset of the pandemic; however, pricing information is not available for any of those transactions.
Based on the data for acquisitions for which core deposit intangible detail was reported, a majority of banks selected a ten-year amortization term for the CDI values booked. Less than 10% of transactions for which data was available selected amortization terms longer than ten years. Amortization methods were somewhat more varied, but an accelerated amortization method was selected in approximately half of these transactions.
For more information about Mercer Capital’s core deposit valuation services, please contact us.
The outbreak of COVID-19 in the United States has caused a severe public health crisis and an unprecedented level of economic disruption. While some economic activity is beginning to come back, predictions for longer-term negative economic impacts have also become more prevalent.
The initial thoughts of a quick V-shaped economic recovery have been replaced in all but the most optimistic minds with a more nuanced consideration of how this situation will impact businesses within different industries and geographic areas over the next several years.
In some of the most hard-hit industries, we are already seeing what is expected to be a prolonged surge in corporate restructurings and bankruptcy filings.
The decision to file for bankruptcy does not necessarily signal the demise of the business. If executed properly, Chapter 11 reorganization affords a financially distressed or insolvent company an opportunity to restructure its liabilities and emerge from the proceedings as a viable going concern. Along with a bankruptcy filing (more typically before and/or in preparation for the filing), the company usually undertakes a strategic review of its operations, including opportunities to shed assets or even lines of business. During the reorganization proceeding, stakeholders, including creditors and equity holders, negotiate and litigate to establish economic interests in the emerging entity. The Chapter 11 reorganization process concludes when the bankruptcy court confirms a reorganization plan that both specifies a reorganization value and reflects the agreed upon strategic direction and capital structure of the emerging entity.
In addition to fulfilling technical requirements of the bankruptcy code and providing adequate disclosure, two characteristics of a reorganization plan are germane from a valuation perspective1 :
Finally, upon emerging from bankruptcy, companies are required to apply “fresh start” accounting, under which all assets of the company, including identifiable intangible assets, are recorded on the balance sheet at fair value.
Within this context of a best interests test, valuation specialists can provide useful financial advice to:
If a company can no longer pay its debts and does not restructure, it will undergo Chapter 7 liquidation. The law generally mandates that Chapter 11 restructuring only be approved if it provides a company’s creditors with their highest level of expected repayment. The Chapter 11 restructuring plan must be in the best interest of the creditors (relative to Chapter 7 liquidation) in order for it to be approved. 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 first valuation step in successful Chapter 11 restructuring is assessing the alternative, liquidation value
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 generally 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.
Everyone has seen the “inventory liquidation sale” sign or the “going out of business” sign in the shop window. Experience tells us that the underlying “marketing period” assumptions made in a liquidation analysis can have a material impact on the valuation conclusion.
From a technical perspective, liquidation value can occur under three sub-sets: assemblage of assets, orderly liquidation, and forced liquidation. As implied, these are asset-based approaches to valuation that differ in their assumptions surrounding the marketing period and manner in which the assets are disposed. There are no strict guidelines in the bankruptcy process related to these three sub-sets; bankruptcy courts generally determine the applicable premise of value on a case by case basis.
The determination (and support) of the appropriate premise can be an important component to the best interests test.
In general, the discount from fair market value implied by the price obtainable under a liquidation premise is 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 typically be applied to cash and equivalents while less liquid assets (such as accounts receivable or inventory) would likely incur potentially significant discounts. For some assets categories, the appropriate level of discount can be estimated by analyzing the prices commanded in the sale of comparable assets under a similarly distressed sale scenario.
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 stakeholders than discounted asset sales. ASC 852 defines reorganization value as2:
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 valued based on the return that would be generated by the future operations of the emerging, restructured entity and not what one would be paid for selling individual assets.
To measure enterprise value … reorganization plans primarily use a type of income approach – the discounted cash-flow (DCF) method
The intangible elements of going concern value result from factors such as having a trained work force, a loyal customer base, an operational plant, and the necessary licenses, systems, and procedures in place. 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:
The sum of the present values of all the forecasted cash flows, including discrete period cash flows and the terminal value, provides an indication of the business enterprise value of the emerging entity for a specific set of forecast assumptions.
The reorganization value is the sum of that expected business enterprise value of the emerging entity and proceeds from any sale or other disposal of assets during the reorganization.
Since the DCF-determined part of this value relies on so many forecast assumptions, different stakeholders may independently develop distinct estimates of the reorganization value to facilitate negotiations or litigation.
The eventual confirmed reorganization plan, however, reflects the terms agreed upon by the consenting stakeholders and specifies either a range of reorganization values or a single point estimate.
In conjunction with the reorganization plan, the courts also approve the amounts of allowed claims or interests for the stakeholders in the restructuring entity. From the perspective of the stakeholders, the reorganization value represents all of the resources available to meet the post-petition liabilities (liabilities from continued operations during restructuring) and allowed claims and interests called for in the confirmed reorganization plan.
If this agreed upon reorganization value exceeds the value to the stakeholders of the liquidation, then there is only one more valuation hurdle to be cleared: a cash flow test. This is an examination of whether the restructuring creates a company that will be viable for the long term—that is not likely to be back in bankruptcy court in a few years
For a company that passes the best interest test, this second requirement represents the last valuation hurdle to successfully emerging from Chapter 11 restructuring. Within the context of a cash flow test, valuation specialists can demonstrate the viability of the emerging entity’s proposed capital structure, including debt amounts and terms given the stream of cash flows that can be reasonably expected from the business. The cash flow test essentially represents a test of the company’s current and projected future financial solvency.
Even if a company shows that the restructuring plan will benefit stakeholders relative to liquidation, 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 cash flow test essentially represents a test of the company’s current and projected future financial solvency
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. 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. The answer, however, is typically not so simple as assessing a single cash flow forecast.
It is a rare occurrence when management’s base case forecast does not pass the cash flow test. The underpinnings of the entire reorganization plan are based on this forecast, so it is almost certain that the cash flow projections have been produced with an eye toward meeting this requirement.
Viability is proven not only by passing the cash flow test on a base case scenario but also maintaining financial viability under some set of reasonable projections in which the company (or industry, or general economy) underperforms the base level of expectations. This “stress-testing” of the company’s financial projection is a critical component of a meaningful cash flow test.
Companies emerging from Chapter 11 bankruptcy are required to re-state their balance sheets to conform to the reorganization value and plan.
Implementing “fresh start” accounting requires valuation expertise to develop reasonably accurate fair value measurements.
Although the Chapter 11 process can seem burdensome, a rigorous assessment of cash flows and a company’s capital structure can help the company as it develops a plan for years of future success.
We hope that this explanation of the key valuation-related steps of a Chapter 11 restructuring helps managers realize this potential. However, we also understand that executives 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
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 advising companies on valuation related issues, Mercer Capital’s professionals are well positioned to help in both of these roles. For a confidential conversation about your company’s current financial position and how we might assist in your bankruptcy related analyses, please contact a Mercer Capital professional.
1Accounting Standards Codification Topic 852, Reorganizations (“ASC 852”). ASC 852-05-8.
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In this July 21, 2020 webcast, Travis W. Harms of Mercer Capital and Brook H. Lester of Diversified Trust share their insights with family business directors and their advisors.
As family business leaders tackle the many operating challenges thrust upon them by the COVID-19 pandemic, it is tempting to let tasks like estate planning fall to the bottom of the to-do list. While estate planning may appear to be less pressing than other issues, the positive impact of effective planning on the long-term health of both the family and the family business is hard to overstate.
If your family business is overdue for some ownership transitions, you should not miss the current opportunity for tax-efficient estate planning transfers.
During the divorce process, a listing of assets and liabilities, often referred to as a marital balance sheet or marital estate, is established for the purpose of dividing assets between the divorcing parties. Some assets are easily valued, such as a brokerage account or retirement, which hold marketable securities with readily available prices. Other assets, such as a business or ownership interest in a business, are not as easily valued and require the expertise of a business appraiser. Upon retaining a valuation or financial expert, together with the family law attorney, it is important to understand and agree upon certain factors that set forth a baseline for the valuation. These may be state specific, such as case precedent and state statute. One of these considerations is the valuation date, which differs from state to state.
The valuation date represents the point in time at which the business, or business interest(s), is being valued. The majority of states have adopted the use of a current date, usually as close as possible to mediation or trial date. Other states use date of separation or the date the divorce complaint/petition was filed. See the map on page 2 for a preferred valuation date summary by state (note that the summary may be modifiable for recent updates in state precedent).
Those states that use date of separation or date of complaint/ petition as the valuation date face a bit of “noise” and complexity when the divorce process becomes lengthy and/or when there are significant impacts to the economy and/or industry in which that business operates.
As an example, consider the timeframe from December 31, 2019 to now, Summer 2020, and the economic reverberation of COVID-19. A valuation as of these two dates will look quite different due to changes in actual business performance as well as shifts in future expectations/outlooks for the business and its industry. However, this is not only a consideration for those states which use date of separation or date of petition. This is also an important consideration for matters which have extended over a prolonged period. It is also critical for current matters – we are all aware that much has transpired since December 31, 2019 – as that valuation date may no longer accurately reflect the overall picture of the business, necessitating a secondary valuation, or alternatively, an update to the prior valuation.
Let’s take a deeper dive at understanding the importance of valuation date as it relates to the divorce process.
Laws differ state to state regarding valuation date and standard of value (generally fair market value or fair value). There are other nuances related to the business valuation for divorce process, such as premise of value which is often a going-concern value as opposed to a liquidation value. After the standard of value, premise of value, and the valuation date have been established, the business appraiser must then incorporate relevant known and knowable facts and circumstances at the date of valuation when determining a valuation conclusion. These facts and trends are reflected in historical financial performance, anticipated future operations, and industry/economic conditions and can fluctuate depending on the date of valuation.
Using our prior example, the conditions of Summer 2020 are vastly different than year-end 2019 due to COVID-19. For many businesses, actual performance financial performance in 2020 has been materially different than what was expected for 2020 during December 2019 budgeting processes. The current environment has made the facts and circumstances in anticipated future budget(s), both short-term and long-term, even more meaningful. The income approach reflects the present value of all future cash flows. So, even if a business is performing at lower levels today, that may not necessarily be a permanent impact, particularly if rebound is anticipated. Thus, that value today may be impacted by a short-term decrease in earnings; however, an anticipated future rebound will also impact the valuation today.
It must be pointed out that it would be incorrect to consider the impact of COVID-19 for a valuation date prior to approximately March 2020, as the economic impact of the pandemic was not reasonably known or knowable prior to that date. Therefore, the valuation date is meaningful and a significant consideration in any valuation process, and especially in current conditions. A state that typically requires a date of separation may consider consensus among parties to update to a more recent date as much has changed between then and now.
Valuations of any privately held company involve the understanding and consideration of many factors. We try to avoid absolutes in valuations such as always and never. The true answer to the question of how have valuations of privately held companies been affected by the coronavirus is “It Depends.”
As a general benchmark, the overall performance of the stock market from the beginning of 2020 until now can serve as a guide. The stock market has been volatile since the March global impact from COVID-19 began to unfold. Specific indicators of each subject company, such as actual performance and the economic/industry conditions relative to their geographic footprint, also govern the impact of any potential change in valuation.
The valuation date for purposes of business valuation for marital dissolution is an important issue, even in times without the current COVID-19 conditions. Consider matters that extend into multiple years from time of separation to time of divorce decree. Has the value of the business changed during this time? If the answer is yes, or maybe, another consideration for some clients may be related to the cost of another valuation. However, the importance of an accurate and timely valuation should far outweigh the concerns of additional expense to update a conclusion.
It is important to discuss these elements with your expert as the process may depend on the length of time which has transpired since the original valuation and the facts and circumstances of the business/economy/industry. Your expert will be able to determine if an acceptable update may be simply updating prior calculations; however, if much has changed, such as expectations for the future performance of the business, the approach may involve a secondary valuation using a current date of valuation.
Another consideration to keep in mind: depending on jurisdiction, state law may deem the value of the business after separation but before divorce as separate property. If this is the case, two valuation dates are necessary.
The litigation environment is complex and already rife with doom and gloom expectations. We have previously written about the phenomenon referred to as divorce recession in family law engagements. Understanding the valuation date of an asset valuation, such as a privately held business, for marital dissolution is an important consideration, especially for matters which have extended over a lengthy time and those that may be impacted by significant global events such as COVID-19. Speak to your valuation expert when these matters arise. The already complex process of business valuation becomes even more complex with the passing of time and also in the midst of economic uncertainty.
Originally published in Mercer Capital’s Tennessee Family Law Newsletter, Volume 3, No. 2, 2020.
Valuations of a closely held business in the context of litigation such as in a contentious divorce, shareholder dispute, damages matter or other litigated corporate matter can be multifaceted and may require additional forensic investigative scrutiny. As such, it is important to consider the potential forensic implications of valuation adjustments as they may lead to other analyses. For example, in a divorce business appraisal, a valuation adjustment for discretionary (personal) expenses may, in turn, provide an implied “true income” and pay ability of a spouse. This is but one example – this session addresses other examples you will likely face.
Presented at the NACVA 2020 Business Valuation and Financial Litigation Virtual Super Conference.
A stress test is defined as a risk management tool that consists of estimating the bank’s financial position over a time horizon – approximately two years – under different scenarios (typically a baseline, adverse, and severe scenario).
The concept of stress testing for banks and credit unions is akin to the human experience of going in for a check up and running on a treadmill so your cardiologist can measure how your heart performs under stress. Similar to stress tests performed by doctors, stress tests for financial institutions can ultimately improve the health of the bank or credit union (“CU”).
The benefits of stress testing for financial institutions include:
As many public companies in other industries have pulled earnings guidance due to the uncertainty surrounding the economic outlook amid the coronavirus pandemic, community banks and CUs do not have that luxury. Key stakeholders, boards, and regulators will desire a better understanding of the ability of the bank or CU to withstand the severe economic shock of the pandemic. Fortunately, stress testing has been a part of the banking lexicon since the last global financial crisis began in 2008. We can leverage many lessons learned from the last decade or so of this annual exercise.
It can be easy to get overwhelmed when faced with scenario and capital planning amidst the backdrop of a global pandemic with a virus whose path and duration is ultimately uncertain. However, it is important to stay grounded in established stress testing steps and techniques.
Below we discuss the four primary steps that we take to help clients conduct a stress test in light of the current economic environment.
It is important to determine the appropriate stress event to consider. Unfortunately, the Federal Reserve’s original 2020 scenarios published in 1Q2020 seem less relevant today since they forecast peak unemployment at 10%, versus the recent peak national unemployment rate of 14.7% (April 2020). However, the Federal Reserve supplemented the original scenario with a sensitivity analysis for the 2020 stress testing round related to coronavirus scenarios in late 2Q20, which provides helpful insights.
The Federal Reserve’s sensitivity analysis had three alternative downside
Some of the key macroeconomic variables in these scenarios are found in Table 1.
In our view, these scenarios provide community banks and credit unions with economic scenarios from which to begin a sound stress testing and capital planning framework.
While determining potential loan losses due to the uncertainty from a pandemic can be particularly daunting, we can take clues from the Federal Reserve’s release of results in late 2Q20 from some of the largest banks. While the specific loss rates for specific banks weren’t disclosed, the Fed’s U, V, and W sensitivity analysis noted that aggregate loss rates were higher than both the Global Financial Crisis (“GFC”) and the Supervisory Capital Assessment Program (“SCAP”) assumptions from the prior downturn.
We note that many community banks and CUs may feel that their portfolios in aggregate will weather the COVID storm better than their larger counterparts (data provided in Table 2). We have previously noted that community bank loan portfolios are more diverse now than during the prior downturn and cumulative charge-offs were lower for community banks as a whole than the larger banks during the GFC. For example, cumulative charge-offs for community banks over a longer distressed time period during the GFC (four years, or sixteen quarters, from June 2008 – June 2012) were 5.1%, implying an annual charge-off rate during a stressed period of 1.28% (which is ~42% of what larger banks experienced during the GFC). However, we also note that this community bank loss history is likely understated by the survivorship bias arising from community banks that failed during the GFC.
Each community bank or CU’s loan portfolio is unique, and it will be important for community banks and CUs to document the composition of their portfolio and segment the portfolio appropriately. Segmentation of the loan portfolio will be particularly important. The Fed noted that certain sectors will behave differently during the COVID downturn. The leisure, hospitality, tourism, retail, and food sectors are likely to have higher credit risk during the pandemic. Proper loan segmentation should include segmentation for higher risk industry sectors during the current pandemic as well as COVID-modified/restructured loans.
Once the portfolio is segmented, loss history over an extended period and a full business cycle (likely 10-12 years of history) will be important to assess. While the current pandemic is a different event, this historical loss experience can be leveraged to provide insights into future prospects and underwriting strength during a downturn and relative to peer loss experience.
In certain situations, it may also be relevant to consider the correlation between those historical losses and certain economic factors such as the unemployment rate in the institution’s market areas. For example, a regression analysis can determine which variables were most significant statistically in driving historical losses during prior downturns and help determine which variables may be most relevant in the current pandemic. For those variables deemed statistically significant, the regression analysis can also provide a forecasting tool to estimate and/or test the reasonableness of future loss rates based on assumed changes in those variables that may be above and beyond historical experience.
Lastly, higher risk loan portfolio segments (such as those in more economically exposed sectors) and larger loans that were modified during the pandemic may need to be supplemented by some “bottom-up” analysis of certain loans to determine how these credits may fare in the different economic scenarios previously described. To the extent losses can be modeled for each individual loan, these losses can be used to estimate losses for those particular loans and also leveraged to support assumptions for other loan portfolio segments.
Step 3 expands the focus beyond just the loan portfolio and potential credit losses from the pandemic modeled in Step 2 and focuses on the institution’s “core” earning power and sensitivity of that over the economic scenarios modeled in Step 1.
When assessing “core” earning power, it is important to consider the potential impact of the economic scenarios on the interest rate outlook and net interest margins (“NIM”). While the outlook is uncertain, Federal Reserve rate cuts have already started to crimp margins.
Beyond the headwinds brought about by the pandemic, it is also important to consider any potential tailwinds in certain countercyclical areas like mortgage banking, PPP loan income, and/or efficiency brought about by greater adoption of digital technology and cost savings from branch closures. Ultimately, the earnings model over the stressed period relies on key assumptions that need to be researched, explained, and supported related to NIM, earning assets, non-interest income, expenses/efficiency, and provision expense in light of the credit losses modeled in Step 2.
Step 4 combines all the work done in Steps 1, 2, and 3 and ultimately models capital levels and ratios over the entirety of the forecast periods (which is normally nine quarters) in the different economic scenarios.
Capital at the end of the forecast period is ultimately a function of capital and reserve levels immediately prior to the stressed period plus earnings or losses generated over the stressed period (inclusive of credit losses and provisions estimated). When assessing capital ratios during the pandemic period, it is important to also consider the impact of any strategic decisions that may help to alleviate stress on capital during this period, such as raising sub-debt, eliminating distributions or share repurchases, and slowing balance sheet growth. For perspective, the results released from the Federal Reserve suggested that under the V, U, and W shaped alternative downside scenarios, the aggregate CET1 capital ratios were 9.5%, 8.1%, and 7.7%, respectively.
What your bank or credit union should do with the results depends on the institution’s specific situation. For example, assume that your stress test reveals a lower exposure to certain economically exposed sectors during the pandemic and some countercyclical strengths such as mortgage banking/asset management/
PPP revenues. This helps your bank or CU maintain relatively strong and healthy performance over the stressed period in terms of capital, asset quality, and earnings performance. This performance could allow for and support a strategic/capital plan involving the continuation of dividends and/or share repurchases, accessing capital and/or sub-debt for growth opportunities, and proactively looking at ways to grow market share both organically and through potential acquisitions during and after the pandemic-induced downturn. For those banks and CUs that include M&A in the strategic/capital plan over the next two years, improved stress testing capabilities at your institution should assist with stress testing the target’s loan portfolio during the due diligence process.
Alternatively, consider a bank that is in a relatively weaker position. In this case, the results may provide key insight that leads to quantifying the potential capital shortfall, if any, relative to either regulatory minimums or internal targets. After estimating the shortfall, management can develop an action plan, which could entail seeking additional common equity, accessing sub-debt, selling branches or higher-risk loan portfolios to shrink the balance sheet, or considering potential merger partners. Integrating the stress test results with identifiable action plans to remediate any capital shortfall can demonstrate that the bank’s existing capital, including any capital enhancement actions taken, is adequate in stressed economic scenarios.
A well-reasoned and documented stress test can provide regulators, directors, and management the comfort of knowing that capital levels are adequate, at a minimum, to withstand the pandemic and maintain the dividend. A stress test can also support other strategies to enhance shareholder value, such as a share buyback plan, higher dividends, a strategic acquisition, or other actions to take advantage of the disruption caused by the pandemic. The results of the stress test should also enhance your bank or credit union’s decision-making process and be incorporated into strategic planning and the management of credit risk, interest rate risk, and capital.
Having successfully completed thousands of engagements for financial institutions over the last 35 years, Mercer Capital has the experience to solve complex financial issues impacting community banks and credit unions during the ups and downs of economic cycles. Mercer Capital can help scale and improve your institution’s stress testing in a variety of ways. We can provide advice and support for assumptions within your bank or credit union’s pre-existing stress test. We can also develop a unique, custom stress test that incorporates your institution’s desired level of complexity and adequately captures the unique risks you face.
Regardless of the approach, the desired outcome is a stress test and capital plan that can be used by managers, directors, and regulators to monitor capital adequacy, manage risk, enhance the bank’s performance, and improve strategic decisions.
For more information on Mercer Capital’s Stress Testing and Capital Planning solutions, contact Jay Wilson at email@example.com.
Originally appeared in Mercer Capital’s Bank Watch, July 2020.
All fair market determinations involve assumptions regarding how buyers and sellers would behave in a transaction involving the subject asset. In a recent Tax Court case, the IRS appraiser applied a novel valuation rationale predicated on transactions that would occur involving assets other than the subject interests being valued. In its ruling, the Court concluded that this approach transgressed the boundaries of what may be assumed in a valuation.
At issue in Grieve was the fair market value of non-voting Class B interests in two family LLCs.
Both Rabbit and Angus were capitalized with Class A voting and Class B non-voting interests. The Class A voting interests comprised 0.2% of the total economic interest in each entity. The Class A voting interests were owned by the taxpayer’s daughter, who exercised control over the investments and operations of the entities.
The taxpayer measured the fair market value of the Class B non-voting interests using commonly accepted methods for family LLCs.
The combined valuation discount applied to the Class B nonvoting interests was on the order of 35% for both Rabbit and Angus, as shown in Exhibit 1.
The IRS adopted a novel approach for determining the fair market value of the Class B non-voting interests.
Noting the disparity in economic interests between the Class A voting (0.2%) and Class B non-voting interests (99.8%), the IRS concluded that a hypothetical willing seller of the Class B non-voting interest would sell the subject interest only after having first acquired the Class A voting interest. Having done so, the owner of the class B non-voting interest could then sell both the Class A voting and Class B nonvoting interests in a single transaction, presumably for net asset value.
If the dollar amount paid of the premium paid for the Class A voting interest is less than the aggregate valuation discount applicable to the Class B non-voting interest, the hypothesized series of transactions would yield more net proceeds than simply selling the Class B non-voting interest by itself. The sequence of transactions assumed in the IRS determination of fair market value is summarized in Exhibit 2.
It is certainly true that – if the Class A voting interests could, in fact, be acquired at the proposed prices – the sequence of transactions assumed by the IRS yield greater net proceeds for the owner of the subject Class B non-voting interests than a direct sale of those interests. However, is the assumed sequence of transactions proposed by the IRS consistent with fair market value?
The Tax Court concluded that the IRS valuation over-stepped the bounds of fair market value. The crux of the Court’s reasoning is summarized in a single sentence from the opinion: “We are looking at the value of the Class B Units on the date of the gifts and not the value of the class B units on the basis of subsequent events that, while within the realm of possibilities, are not reasonably probable, nor the value of the class A units.” Citing a 1934 Supreme Court decision (Olson), the Tax Court notes that “[e]lements affecting the value that depend upon events within the realm of possibility should not be considered if the events are not shown to be reasonably probable.” In view of the fact that (1) the owner of the Class A voting interests expressly denied any willingness to sell the units, (2) the speculative nature of the assumed premiums associated with purchase of those interests, and (3) the absence of any peer review or caselaw support for the IRS valuation methodology, the Tax Court concluded that the sequence of transactions proposed by the IRS were not reasonably probable. As a result, the Tax Court rejected the IRS valuations.
The Grieve decision is a positive outcome for taxpayers. In addition to affirming the propriety of traditional valuation approaches for minority interests in family LLCs, the decision clarified the boundaries of fair market value, rejecting a novel valuation approach that assumes specific attributes of the subject interest of the valuation that do not, in fact, exist. As the Court concluded, fair market value is determined by considering the motivations of willing buyers and sellers of the subject asset, and not the willing buyers and sellers of other assets.
Originally appeared in Value Matters™, Issue No. 3, 2020
Analysts and pundits are debating whether the economic recovery will be shaped like a U, V, W, swoosh, or check mark and how long it may take to fully recover. To find clues, many are following the lead of the healthcare professionals and looking to Asia for economic and market data since these economies experienced the earliest hits and recoveries from the COVID-19 pandemic.
Taking a similar approach led me to take a closer look at the Japanese megabanks for clues about how U.S. banks may navigate the COVID-19 crisis. In Japan, the banking industry is grappling with similar issues as U.S. banks, including the need to further cut costs; expanding branch closures; enhancing digital efforts; bracing for a tough year as bankruptcies rise; and looking for acquisitions in faster growing markets.
Another similarity is impairment charges. Two of the three Japanese megabanks recently reported impairment charges. Mitsubishi UFJ Financial Group (MUFG) reported a ¥343 billion impairment charge related to two Indonesian and Thai lenders that MUFG owned controlling interests in and whose share price had dropped ~50% since acquisition. Mizuho Financial Group incurred a ¥39 billion impairment charge.
In the years since the Global Financial Crisis, there have not been many goodwill impairment charges recognized by U.S. banks. A handful of banks including PacWest (NASDAQ-PACW) and Great Western Bancorp (NYSE-GWB) announced impairment charges with the release of 1Q20 results. Both announced dividend reductions, too.
Absent a rebound in bank stocks, more goodwill impairment charges likely will be recognized this year. Bank stocks remain depressed relative to year-end pricing levels despite some improvements in May and early June. For perspective, the S&P 500 Index was down ~5% from year-end 2019 through May 31, 2020 compared to a decline of ~32% for the SNL Small Cap Bank Index and ~34% for the SNL Bank Index.
This sharper decline for banks reflects concerns around net interest margin compression, future credit losses, and loan growth potential. The declines in the public markets mirrored similar declines in M&A activity and several bank transactions that had previously been announced were terminated before closing with COVID-19 impacts often cited as a key factor.
Price discovery from the public markets tends to be a leading indicator that impairment charges and/or more robust impairment testing is warranted. The declines in the markets led to multiple compression for most public banks and the majority have been priced at discounts to book value since late March. At May 31, 2020, ~77% of publicly traded community banks (i.e., having assets below $5B) were trading at a discount to their book value with a median of ~83%. Within the cohort of banks trading below book value at May 31, 2020, ~74% were trading below tangible book value.
Goodwill impairment testing is typically performed annually. But the unprecedented events precipitated by the COVID-19 pandemic now raise questions whether an interim goodwill impairment test is warranted.
The accounting guidance in ASC 350 prescribes that interim goodwill impairment tests may be necessary in the case of certain “triggering” events. For public companies, perhaps the most easily observable triggering event is a decline in stock price, but other factors may constitute a triggering event. Further, these factors apply to both public and private companies, even those private companies that have previously elected to amortize goodwill under ASU 2017-04.
For interim goodwill impairment tests, ASC 350 notes that management should assess relevant events and circumstances that might make it more likely than not that an impairment condition exists. The guidance provides several examples, several of which are relevant for the bank industry including the following:
The guidance notes that an entity should also consider positive and mitigating events and circumstances that may affect its conclusion. If a recent impairment test has been performed, the headroom between the recent fair value measurement and carrying amount could also be a factor to consider.
Once an entity determines that an interim impairment test is appropriate, a quantitative “Step 1” impairment test is required. Under Step 1, the entity must measure the fair value of the relevant reporting units (or the entire company if the business is defined as a single reporting unit). The fair value of a reporting unit refers to “the price that would be received to sell the unit as a whole in an orderly transaction between market participants at the measurement date.”
For companies that have already adopted ASU 2017-04, the legacy “Step 2” analysis has been eliminated, and the impairment charge is calculated as simply the difference between fair value and carrying amount.
ASC 820 provides a framework for measuring fair value which recognizes the three traditional valuation approaches: the income approach, the market approach, and the cost approach. As with most valuation assignments, judgment is required to determine which approach or approaches are most appropriate given the facts and circumstances. In our experience, the income and market approaches are most used in goodwill impairment testing. However, the market approach is somewhat limited in the current environment given the lack of transaction activity in the banking sector post-COVID-19.
In the current environment, we offer the following thoughts on some areas that are likely to draw additional scrutiny from auditors and regulators.
At a minimum, we anticipate that additional analyses and support will be necessary to address these questions. The documentation from an impairment test at December 31, 2019 might provide a starting point, but the reality is that the economic and market landscape has changed significantly in the first half of 2020.
While not all industries have been impacted in the same way from the COVID-19 pandemic and economic shutdown, the banking industry will not escape unscathed given the depressed valuations observed in the public markets. For public and private banks, it can be difficult to ignore the sustained and significant drop in publicly traded bank stock prices and the implications that this might have on fair value and the potential for goodwill impairment.
At Mercer Capital, we have experience in implementing both the qualitative and quantitative aspects of interim goodwill impairment testing. To discuss the implications and timing of triggering events, please contact a professional in Mercer Capital’s Financial Institutions Group.
Originally published in Bank Watch, June 2020.
Mercer Capital is pleased to prepare a proposal for impairment testing services for your bank or bank holding company. Follow the link below to complete a submission.
Buy-Sell Agreements: Valuation Handbook for Attorneys contains new and important information that will help you draft or revise buy-sell agreements for successful closely held and family business clients around the nation. The goal of this book is to fix ticking time bombs in existing buy-sell agreements and to avoid them altogether in newly drafted agreements.
This book is all about solutions to valuation problems in buy-sell agreements. It provides:
The information and guidance found in this book has been the result of decades of experience working with hundreds of buy-sell agreements and participating in dozens of (mostly flawed) valuation processes as a business appraiser or appraisal consultant.
The book is presented in four parts:
Part I: Buy-Sell Agreement Basics
Part II: Buy-Sell Agreement Pricing Mechanisms
Part III: Recommended Buy-Sell Agreement Pricing Mechanisms
Part IV: Template Language for Valuation Process Buy-Sell Agreements
After five or six years of strong bank M&A activity, 2020 slowed drastically following the onset of COVID-19. Eventually, we expect M&A activity will rebound once buyers have more confidence in the economy and the COVID-19 medical outlook. In that case, there will be greater certainty around seller’s earnings outlook and credit quality, particularly for those loan segments more exposed in the post-COVID-19 economic environment.
The factors that drive consolidation such as buyers’ needs to obtain scale,
improve profitability, and support growth will remain as will seller desires to exit due to shareholder needs for liquidity and management succession among others.
One emerging trend prior to the bank M&A slowdown in March 2020 was credit unions (“CUs”) acquiring small community banks. Since January 1, 2015, there have been 36 acquisitions of banks by CUs of which 15 were announced in 2019.
In addition to the factors favoring consolidation noted above, credit unions can benefit from diversifying their loan portfolio away from a heavy reliance on consumers and into new geographic markets. In addition to diversification benefits, bank acquisitions can also enhance the growth profile of the acquiring CU.
From the first quarter of 2015 through the second quarter of 2019, CU bank buyers grew their membership by ~23% compared to ~15% for other CUs according to S&P Global Market Intelligence. A positive for community bank sellers is that CUs pay cash and often acquire small community banks located in small communities or even rural areas, that do not interest most large community and regional bank acquirers.
There are, of course, unique valuation issues to consider when a credit union buys (or is bidding for) a commercial bank.
Based upon our experience of working as the financial advisor to credit unions that are contemplating an acquisition of a bank, we see three broad factors CUs should consider.
Developing a reasonable valuation for a bank target is important in any economic environment but particularly so in the post-COVID-19 environment. Generally, the guideline M&A comparable transactions and discounted cash flow (“DCF”) valuation methods are relied upon.
In the pre-COVID-19 environment, transaction data was more readily available so that one could tailor one or more M&A comp groups that closely reflected the target’s geographic location, asset size, financial performance, and the like. Until sufficient M&A activity resumes, timely and relevant market data is limited. Even when M&A activity resumes, inferences from historical data for CU deals should be made with caution because it is a small sample set of ~35 pre-COVID-19 deals where only 75% of announced deals since 2015 included pricing data with a wide P/TBV range of ~0.5x to ~1.7x (with a median of ~1.3x).
While deal values are often reported and compared based upon multiples of tangible book value, CU acquirers are like most bank acquirers in which value is a function of projected cash flow estimates that they believe the bank target can produce in the future once merged with their CU.
A key question to consider is: What factors drive the cash flow forecast and ultimately value? No two valuations or cash flow estimates are alike and determining the value for a bank or its branches requires evaluating both qualitative and quantitative factors bearing on the target bank’s current performance, outlook, growth potential, and risk attributes.
The primary factors driving value in our experience include considering both qualitative and quantitative factors. In a post-COVID-19 valuation, a CU may have a high degree of confidence in expense savings, but less so in other aspects of the forecast—especially related to growth potential, credit losses, and the net interest margin (“NIM”).
It is important for CUs to develop reasonable and accurate fair value estimates as these estimates will impact the pro forma net worth of the CU at closing as well as their future earnings and net worth. In the initial accounting for a bank acquisition by a CU, acquired assets and liabilities are marked to their fair values, with the most significant marks typically for the loan portfolio followed by depositor customer relationship (core deposit) intangible assets.
Once a valuation range is determined and the pro forma balance sheet is prepared, the CU can then begin to model certain deal metrics to assess the strength and weaknesses of the transaction. Many of the traditional metrics that banks utilize when assessing bank targets are also commonplace for CUs to evaluate and consider, including net worth (or book value) dilution and the earnback period, earnings accretion/dilution, and an IRR analysis. These and other measures usually are meaningfully impacted by the opportunity cost of cash allocated to the purchase and retention estimates for accounts and lines of business that may have an uncertain future as part of a CU.
One deal metric that often gets a lot of focus from CUs is the estimated internal rate of return (“IRR”) for the transaction based upon the following key items: the cash price for the acquisitions, the opportunity cost of the cash, and the forecast cash flows/valuation for the target inclusive of any expense savings and growth/attrition over time in lines of business. This IRR estimate can then be compared to the CU’s historical and/or projected return on equity or net worth to assess whether the transaction offers the potential to enhance pro forma cash flow and provide a reasonable return to the CU and its members. In our experience, an IRR estimate 200-500 basis points (2-5%) above the CUs historical return on equity (net worth) implies an attractive acquisition candidate.
Mercer Capital has significant experience providing valuation, due diligence, and advisory services to credit unions and community banks across each phase of a potential transaction. Our services for CUs include providing initial valuation ranges to CUs for bank targets, performing due diligence on targets during the negotiation phase, providing fairness opinions and presentations related to the acquisition to the CU’s management and/or Board, and providing valuations for fair value estimates of loans and core deposit prior to or at closing.
We also provide valuation and advisory services to community banks considering strategic options and can assist with developing a process to maximize valuation upon exit by including a credit union in the transaction process. Feel free to reach out to us to discuss your community bank or credit union’s unique situation in confidence.
Originally published in Bank Watch, May 2020.
The National Restaurant Association’s Restaurant Performance Index for March dropped to its lowest level since the Index began in 2002. The 95.0 reading was down from 101.9 in February, with 100 being the separator between expansion and contraction. The RPI is equally weighted between the Current Situation Index (93.1) and the Expectations Index (97.0). The Expectations Index is usually the higher of the two and measures operators 6-month outlook, but it is telling that this figure is still below 100 looking out to September.
Coming into 2020, there was a growing chasm between the valuations of many restaurant brands that get significant franchise royalty revenues and their franchisee operating counterparts. Franchisee valuations have lagged as margins have been squeezed by factors including costly third-party delivery services. Perhaps these costs will be abated once this subindustry experiences some consolidation like Uber’s recently announced attempted takeover of Grubhub. Or maybe this will further squeeze the bottom line for restaurant operators as these delivery companies compete less. Either way, franchisors clipping royalties off the top of revenues have been protected, and their asset lite approach has streamlined operations. However, the success of this business model is premised on the idea that operator margins may be squeezed but their revenues will not materially decline. The demand shock created by COVID has burst the bubble on this investment thesis, which has brought down valuations for franchisors and operators alike. It will be interesting to see going forward how this impacts the separation between brand and operator as franchisees have long bemoaned expensive capex requirements that are a use of cash and may increase revenues and profits in unequal measure.
Restaurants with significant leverage (debt or other fixed costs such as rent not tied to a % of sales) are likely to fare worse than others. Brand may also play an increased role as consumers seek to “support local.” Stay-at-home orders have seen grocery bills increase and restaurant trips confined to takeout. In certain areas, restrictions have been eased including Nashville, where retail and restaurant businesses are allowed to open at 50% capacity as part of Phase One of the city’s reopening plan. While government’s allowing restaurants to reopen is the first step to returning to normalcy, there are many more steps to go. First, restaurants must be willing to reopen amidst concerns about staffing and profitability. For restaurants to be willing to open, they must believe customers will be willing to return as well.
Despite now being allowed to open, not all restaurants will opt to flip the switch and open their doors. There is a myriad of potential reasons, but we will highlight a couple key issues. First is labor. In April, 20.5 million jobs were lost, and 5.5 million of these were in food services. Rehiring at this scale doesn’t happen overnight. Also, the CARES Act signed on March 27th increased unemployment benefits by $600 per week through the end of July. For an employee making $10/hour in Tennessee, they would be eligible for a total of $800/week in benefits from unemployment between state and federal. While unemployment originally would have only replaced half of the worker’s $400/week wage, they would now be receiving double. This significantly impairs the ability of restaurant owners to compel staff to return.
This presents a problem for employers who are required to restore employment under the terms of the PPP to make loans forgivable. On May 3rd, the Treasury Department issued guidance that if businesses could document a rejected written offer, this employee will be excluded from the forgiveness calculation. Receiving unemployment benefits requires people to be “actively searching” for a job. While this has historically been only minimally enforceable, the PPP loans will cause written documentation to be provided to the government that people are ineligible for unemployment, which may increase compliance. But this will strain labor relations as many will view themselves as underpaid.
An effective pay cut is not the only thing that would keep staff away from work. Even management-level employees are not necessarily eager to return to work with the potential health and safety risks. While staying below full capacity is likely safer than reopening all at once, the risk is certainly not eliminated. People have been strongly encouraged or required to wear masks in public, but masks will be decidedly less prevalent in between bites of a meal.
Finally, restaurant owners have to perform their own cost benefit analysis as to whether it makes sense to reopen, just like they had to determine whether or not to offer takeout or close entirely. Certain overhead expenses like rent are considered a cost of doing business, except for some companies who opted to forego rent payments. Many expenses, however, are variable such as food costs. If restaurant owners decide to reopen their doors, they will have to pay for inventory, bring back workers, and incur the majority of their typical expenses. Incorrectly projecting consumer behavior can lead to spoilage. On the other hand, people returning to their favorite restaurants expecting their favorite menu item may deal a blow to reputation if items aren’t properly stocked. For many, reopening will not make sense if revenues are only 25-50%.
In the March 2020 Bank Watch, we provided our first impressions of the “reshaping landscape” created by the COVID-19 pandemic and its unfolding economic consequences. This month, we expand upon the potential asset quality implications of the current environment.
One word that aptly describes the credit risk environment is inchoate, which is defined as “imperfectly formed or formulated” or “undeveloped.” We can satiate our analytical curiosity daily by observing trends in positive COVID-19 cases, but credit quality concerns created by the pandemic and its economic shocks lurk, barely perceptible in March 31, 2020 asset quality metrics such as delinquencies or criticized loans. However, the pandemic’s effect on bank stock prices has been quite perceptible, with publicly-traded bank stocks underperforming broad-market benchmarks due to concerns arising from both asset quality issues and an indefinite low interest rate environment. Bridging this gap between market perceptions and current asset quality metrics is the focus of this article.
At the outset, we should recognize the limitations on our oracular abilities. Forward-looking credit quality estimates now involve too many variables than can comfortably fit within an Excel spreadsheet—case rates, future waves of positive diagnoses, treatment and vaccine development, and governmental responses. The duration of the downturn, however, likely will have the most significant implications for banks’ credit quality.
We neither wish to overstate our forecasting capacity nor exaggerate the ultimate loss exposure. We recognize that transactions are occurring in the debt capital markets involving issuers highly exposed to the pandemic’s effects on travel and consumption—airlines, cruise operators, hotel companies, and automobile manufacturers. Investors in these offerings exhibit an ability to peer beyond the next one or two quarters or perhaps have faith that the Fed may purchase the issue too.
To assess the nascent credit risk, our loan portfolio analyses augment traditional asset quality metrics with the following:
A Farewell to Arms (1929) by Ernest Hemingway, which provides the preceding quotation, speaks to a longing for normality as the protagonist escapes the front lines of World War I. While perhaps a metaphor for our time, the quotation—with apologies to Hemingway—also fits the 2008 to 2009 financial crisis (“the world breaks everyone”) and uncertainties regarding banks’ preparedness for the current crisis (will the industry prove “strong in the [formerly] broken places”?).
To simulate credit losses in an environment marked by a rapid increase in unemployment and an abrupt drop in GDP, analysts are using the Great Financial Crisis as a reference point. Is this reasonable? Guardedly, yes; in part because no preferable alternatives exist. But how may the current crisis develop differently, though, in terms of future loan losses?
Table 1 presents aggregate loan balances for community banks at June 30, 2002 and June 30, 2007, the final period prior to the Great Financial Crisis’ onset. One evident trend during this five year period is the grossly unbalanced growth in construction and development lending, which led to outsized losses in subsequent years. Have similar imbalances emerged more recently?
We can observe in Table 2 that loans have not increased as quickly over the past five years as over the period leading up to the Global Financial Crisis (67% for the most recent five year period, versus 90% for the historical period). Further, the growth rates between the various loan categories remained relatively consistent, unlike in the 2002 to 2007 period. The needle looking to pop the proverbial bubble has no obvious target.
Using the same data set, we also calculated in Table 3 the cumulative loss rates realized between June 30, 2008 and June 30, 2012 relative to loans existing at June 30, 2008.
This analysis indicates that banks realized cumulative charge-offs of 5.1% of June 30, 2008 loans, although this calculation may be understated by the survivorship bias created by failed banks. The misplaced optimism regarding construction loans resulted in losses that significantly exceeded other real estate loan categories. Consumer loan losses are exaggerated by certain niche consumer lenders targeting a lower credit score clientele.
Are these historical loss rates applicable to the current environment? Table 4 compares charge-off rates for banks in Uniform Bank Performance Report peer group 4 (banks with assets between $1 and $3 billion). Loss rates entering the Great Financial Crisis and the COVID-19 pandemic are remarkably similar.
We would not expect the disparity in loss rates between construction and development lending versus other real estate loan categories to arise again (or at least to the same degree). Community banks generally eschew consumer lending; thus, consumer loan losses likely will not comprise a substantial share of charge-offs for most community banks. For consumer lending, the credit union industry likely will experience greater fall-out if unemployment rates reach the teens.
Regarding community banks, we have greater concern regarding the following:
In the Great Financial Crisis, banks located in more rural areas often outperformed, from a credit standpoint, their metropolitan peers, especially if they avoided purchasing out-of-market loan participations. This often reflected a tailwind from the agricultural sector. It would not be surprising if this occurs again. Agriculture has struggled for several years, weeding out weaker, overleveraged borrowers.
Additionally, to the extent that the inherent geographic dispersion of more rural areas limits the spread of the coronavirus, along with less dependence on the hospitality and tourism sectors, rural banks may again experience better credit performance.
The Plague (1947) by Albert Camus describes an epidemic sweeping an Algerian city but often is read as an allegorical tale regarding the French resistance in World War II. Sales of The Plague reportedly have tripled in Italy since the COVID-19 pandemic began, while its English publisher is rushing a reprint as quarantined readers seek perspective from Camus’ account of a village quarantined due to the ravaging bubonic plague.
As Camus observed for his Algerian city, we also suspect that banks will not be free of asset quality concerns so long as COVID-19 persists. Another source of perspective regarding the credit quality outlook comes from the rating agencies and SEC filings by publicly-traded banks:
Banks tend to be senior lenders in borrowers’ capital structure; thus, the rating agency data has somewhat limited applicability. Shadow lenders like business development companies and private credit lenders likely are more exposed than banks. Nevertheless, the data indicate that the rating agencies are expecting default and delinquency rates similar to the Great Financial Crisis. As for Camus’ narrator, the ultimate duration of the pandemic will determine when normality resumes. Lingering credit issues may persist, though, until well after the threat from COVID-19 recedes.
Community banks rightfully pride themselves as the lenders to America’s small business sector. These small businesses, though, often are more exposed to COVID-19 countermeasures and possess smaller buffers to absorb unexpected deterioration in business conditions relative to larger companies. Permanent changes in how businesses conduct operations and consumers behave will occur as new habits congeal. This leaves the community bank sector at risk. However, other factors support the industry’s ability to survive the turmoil:
Nonetheless, credit losses tend to be episodic for the industry, occurring between long stretches of low credit losses. The immediate issue remains how high this cycle’s losses go before returning to the normality that ensues in Hemingway and Camus’ work after war and pestilence.
1 Emmanuel Louis Bacani, “US Speculative-Grade Default Rate to Jump Toward Financial Crisis Peak – Moody’s,” S&P Global Market Intelligence, April 24, 2020
2 Fitch Ratings, U.S. LF/CLO Weekly, April 24, 2020.
3 Fitch Ratings, North American CMBS Market Trends, April 24, 2020.
4 Fitch Ratings, U.S. CMBS Delinquencies Projected to Approach Great Recession Peak Due to Coronavirus, April 9, 2020.
5 Fitch Ratings, Update on Response on Coronavirus Related Reviews for North American CMBS, April 13, 2020.
6 Jake Mooney and Robert Clark, “US Banks Detail Exposure to Reeling Hotel Industry in Q1 Filings,” S&P Global Market Intelligence, April 24, 2020
7 Tom Yeatts and Robert Clark, “First Financial, Pinnacle Rank Among Banks with Most Retail Exposure,” S&P Global Market Intelligence, April 27, 2020
Originally published in Bank Watch, April 2020.
March 2020 probably will prove to be among the most dramatic months for financial markets in US history. Likewise, the fallout for banks may take a year or so to fully appreciate. Nonetheless, in this issue of BankWatch, we offer our initial thoughts as it relates to the industry.
U.S. equity markets have entered a bear market, the definition of which is a drop of at least 20%. As of March 27, 2020, the S&P 500 had declined 21% year-to-date and the Russell 2000 was down 32%. Not surprisingly banks have fared worse with the SNL Large Cap Bank Index falling 39% given the implications for credit because of the government’s mandated shutdown of broad swaths of the economy due to COVID-19.
Bear markets vary in length and depend upon the severity of the economic downturn, the value of assets before the downturn started, and policy responses among other factors. The 2001 recession, which was shallow, started in March and ended in November according to government statisticians; however, the bear market for equities as measured by the S&P 500 was brutal (-49%) that ran from March 2000 to November 2002. Banks trended modestly higher during 2000-2002 because they entered the downturn cheap to their late 1990s valuations and because real estate values did not fall.
The Great Financial Crisis (“GFC1”) that ran from August 2007, when the Bear Stearns hedge funds failed, through year-end 2009 entailed a bear market that saw a 57% reduction in the S&P 500 between October 2007 and the bottom on March 9, 2009. Economists tell us the recession occurred from year-end 2007 through June 30, 2009. Unlike 2000-2002, banks were a disaster for investors because credit losses were high, and many had to raise equity at low prices to survive.
We do not know how much further bank stocks may fall if at all from late March in what we are taking liberty to define as GFC2. Figure 1 provides perspective on how banks—here defined as SNL’s Small Cap US Bank Index—performed in the two-year period ended March 9, 2009, and March 27, 2020. During GFC1 the bank index fell almost 70% to when the bear market ended. (March 9 was near the date when FASB eased mark-to-market rules and the Obama Administration signaled it would not nationalize the banks.)
By contrast the bank index traded sideways between March 2018 and early 2020 before plummeting about 40% at the lowest point in March as investors rushed for the exits as economic activity crashed. Massive intervention in the markets by the Fed has arrested the decline in financial assets for now, but in doing so the important market function of price discovery and therefore capital allocation has been distorted.
Relative to history banks are cheap, but that does not mean they cannot get cheaper. Alternatively, valuation multiples may rise because EPS and TBVPS fall more than share prices fall or even trade sideways or higher from here. Presumably GFC2 will be like GFC1 and most bear markets in which prices fall in anticipation of earnings that will decline later as the market discounts fundamentals that are expected to prevail 6-18 months in the future.
As of late March, bank stocks were cheap to long-term average multiples with small cap banks trading for 9.4x trailing 12-month earnings and 105% of TBV compared to 7.9x and 122% for the large cap bank index. Dividend yields around 4% are enticing, too, but the downturn could be sufficiently severe to force widescale dividend cuts. We do not know and will not know until the future arrives.
Interestingly, small cap banks as of March 27 were trading below the March 9, 2009, bottom at 105% of TBV vs. 118% nine years ago.
Perhaps one of the more depressing expectations for banks is not that credit losses will increase but the Fed promise that short-term rates will remain anchored near zero for the foreseeable future. As shown in Figure 3, the market expects 30/90 day LIBOR to fall from current distressed levels in excess of 1.0% to around 0.3% within a few months and remain anchored there for a couple of years.
Those who follow the forward curves know that forward rate expectations can change quickly. Nonetheless, the market today expects LIBOR benchmark rates (and SOFR) to fall toward the Fed Funds target range.
Our expectation is that NIMs may fall below the last cycle low of ~3.5% recorded in 1H09 because asset yields are much lower today than in 2008 when the GFC1 was gathering steam. Likewise, deposit rates can be cut somewhat but they, too, are much lower now than was the case in 2008. By way of comparison the NIM for banks with $1 billion to $10 billion of assets in 4Q06 was 3.74% according to the FDIC. By 1H09 the NIM for the group had declined to less than 3.4%. As of 4Q19 the NIM was 3.67%.
We do not know how high credit costs will go. According to the FDIC, losses approximated 2% of loans in 2009 for banks with $1 billion to $10 billion of assets and 3% for banks with $10 billion to $250 billion of assets. Losses were especially high in C&D portfolios because residential mortgage was the epicenter of the last downturn.
This time more asset classes look to be at risk because a deflationary shock has been unleashed on the global economy.
The hardest hit sectors within most bank loan portfolios will be hotels and restaurants as part of the travel and leisure industry that has been impacted the most by COVID-19. Among a subset of banks in the Southwest, Dakotas and Appalachia potentially will be sizable losses in energy-related credits as oil and gas are at the epicenter of this deflationary shock. Retail CRE will see more problem assets, too, as the shutdown accelerates the shift to digital commerce.
An unknown element is how shifts in consumer and business behaviors may impact credit losses. One surprise from the last recession was the move by consumers to pay auto and credit card loans while defaulting on mortgages in order to commute to work and maintain access to revolving credit. Previously consumers would default on other borrowings to save the home. The behavior was an admission by many consumers that they overpaid for houses and were willing to return to renting.
In this downturn maybe consumers will let auto loans go because the average auto loan is much larger and has a longer duration than a decade ago, and ride sharing lessens the need for a car. Businesses may decide that much less office space is needed as employees become more adept at working remotely.
In short, it is easy to construct a scenario in which credit losses are higher than those experienced during 2008-2010, but it is too early to know for certain. One interesting market data point arguing perhaps not is high yield bonds. The option-adjusted spread (“OAS”) on the ICE BofA High Yield Index peaked on March 23 at 1087bps versus 1988bps in November 2008.
If credit losses are notably higher than what was experienced in 2008 then an informal form of regulatory forbearance may be allowed in which losses are slowly recognized to protect capital. Past precedence includes the Lesser Developed Country (“LDC”) crisis of the early and mid-1980s in which money center banks took 5-6 years to write-off large exposures to LDCs as a result of a collapse in oil and commodity prices.
As shown in Figure 5, US banks are much better capitalized today than at year-end 2006 immediately before GFC1 began. Ironically, the severely adverse scenario in the DFAST-mandated stress tests will be tested given the magnitude of the economic shut-down. All 18 large-cap banks that were subjected to the Fed’s 2019 test passed with leverage ratios bottoming over an eight-quarter period in the vicinity of 6-7%. Results can be found at the following link https://mer.cr/2JswW1d.
A secondary issue is the outlook for common and preferred dividends. We expect first quarter and perhaps second quarter dividends to be paid; however, beginning in the third quarter dividend reductions and omissions are possible if not probable once a better estimate of losses is developed. Aside from written agreements with regulators that preclude payments we assume sub debt coupon payments will continue to be made because a missed coupon payment is an event of default unlike trust preferred securities that provided issuers 20 quarters to miss a payment without tripping a default.
Finally, M&A will become more imperative among commercial banks as NIMs go much lower. Executives of Truist Financial Corporation likely are relieved that the respective boards of directors of SunTrust and BB&T had the courage to combine to extract significant cost savings on what will be a lower run-rate of revenues than originally envisioned.
As for investors and M&A participants, the challenge as always will be first to think about earning power rather than next year’s estimate and what is a reasonable valuation in terms of earning power. That, of course, is easier said than done when markets are rapidly repricing for a new order.
Originally published in Bank Watch, March 2020.
We recognize what matters today for many funds is helping portfolio companies survive a sharp drop in revenues rather than discerning how much first quarter marks may fall from the last valuation.
Scooter rental firm Lime reportedly is trying to raise capital at a valuation that is 80% below its last raise. Dilution and a valuation mark-down may be a bitter pill for existing investors, but for many money losing enterprises with dwindling cash such as Lime, it is unavoidable if the firm is to survive.
Our focus is on valuing illiquid securities, not sourcing capital. One of our colleagues once said that valuing private equity and credit portfolios is about marking as close to market as possible; it is not marking to a price target predicated on an investment thesis. The accountants provide perspective and guidance, but not precision beyond the preference hierarchy of Level 1 vs. Level 2 vs. Level 3 valuation inputs. ASC 820-10-20 defines fair value as, “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” Fair value from the accountant’s perspective represents the exit price of the subject asset for a market participant in the principal or most advantageous market. Exit multiples are a theoretical concept today in which private equity and credit markets are frozen, but that will not always be the case. One never knows how much price dislocation is due to illiquidity vs. the market’s reassessment of fundamentals. Time will tell, but the impact of the governments response to COVID-19 on the economy is unlikely to be transitory. As it relates to marking private equity and credit to market or some semblance thereof, we offer these initial thoughts:
So how does one value private equity and credit in a developing recession or depression that may be very deep and of an unknown duration? Our view is that investors will be more focused than ever on cash flow and earning power because the era of ridiculous valuations on flimsy pro-forma EBITDA is over.
Table 1 provides a sample overview of the template we use at Mercer Capital. The process is not intended to create an alternate reality; rather, it is designed to shed light on core trends about where the company has been and where it may be headed. Adjustments are intended to strip-out non-recurring items and items that are not related to the operations of the business.
In addition, EBITDA is but one measure to be examined because EBITDA is a good base earnings measure, but it does not measure cash flow. Capex, working capital and debt service requirements are to be considered, too.
The adjusted earnings history should create a bridge to next year’s budget, and the budget a bridge to multi-year projections. The basic question to be addressed: Does the historical trend in adjusted earnings lead one to conclude that the budget and multi-year projections are reasonable with the underlying premise that the adjustments applied are reasonable?
The analysis also is to be used to derive earning power. Earning power represents a base earning measure that is representative through the firm’s (or industry’s) business cycle and therefore requires examination of earnings over an entire business cycle. If the company has grown such that adjusted earnings several years ago are less relevant, then earning power can be derived from the product of a representative revenue measure such as the latest 12 months or even the budget and an average EBITDA margin over the business cycle.
Terminal values like cash flow will be subjected to more scrutiny, too. As noted previously, guideline transaction data is not as informative today given the change to the economy that has occurred. That is not to say guideline company and transaction data is not relevant, but probably requires a larger than normal haircut for fundamental adjustment.
Alternatively, the build-up method in which current earning power and the terminal value cash flow in a DCF model are capitalized may provide a better estimate of fair value than pre-COVID transaction data.
Table 2 presents a perspective on why market participants may often times conclude the multiple applicable to a given company should be lower in the post-COVID-19 world. The process will lead to lower values than would have been derived prior to February 2020 because earning power and cash flow projections will be lower; risk premium applied to develop a weighted average cost of capital will be greater; and the expected long-term growth rate in earning power will be lower. That may change over time as risk premia recede and business cash flows rebound, but that is not the world that exists today as it relates to marking-to-market (or model).
Originally published in Mercer Capital’s Portfolio Valuation | Private Equity and Credit Newsletter