The outbreak of the COVID-19 pandemic 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 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.
While some oil & gas industry bankruptcies have already occurred, expectations for many more to come are widely held.
In the first half of 2020, the U.S. oil and gas industry suffered what was arguably its worst six-month period ever. The combined impact of the Saudi/Russian price war and the drop in energy demand due to the onslaught of the COVID-19 pandemic was unprecedented. Brent crude prices that had begun the year near $67 per barrel had dropped to $50 per barrel by early March before plummeting to $19 per barrel by the end of the quarter when the Saudi/Russia spat was in full force, but while the impact of the pandemic was still materializing. Since the start of the pandemic, liquid fuel consumption has dropped by 15% with production levels falling 10%. Drilling activity has been even harder hit with rig counts (active rotary rigs) now at a mere 30% of early first quarter levels. Despite oil prices having partially recovered, oilfield activity remains anemic with the OFS industry having shed nearly 90,000 jobs through May. While in a few areas oil and gas can be produced profitably at mid-year 2020 prices (WTI at 38.31 and Henry Hub at $1.63), most areas cannot. Thus, while some oil & gas industry bankruptcies have already occurred, expectations for many more to come are widely held.
For oil & gas companies, 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 perspective:1
1. The plan should demonstrate that the economic outcomes for any consenting stakeholders are superior under Chapter 11 proceeding compared to a Chapter 7 proceeding, which provides for more direct relief through a liquidation of the business. This is generally referred to as the “best interests test.”
2. The plan should demonstrate that, upon confirmation by the bankruptcy court, it will not likely result in liquidation or further reorganization of the business. This is generally referred to as the “cash flow test.”
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.
Best Interests Test
Within this context of a best interests test, valuation specialists can provide useful financial advice to:
- Establish the value of the business under a Chapter 7 liquidation premise.
- Measure the reorganization value of a business, which, absent liquidation, represents the economic “pie” from which stakeholder claims can be satisfied. A plan confirmed by a bankruptcy court should establish a reorganization value that exceeds the value of the company under a liquidation premise.
A Floor Value: Liquidation Value
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 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.
Liquidation value can occur under three sub-sets: assemblage of assets, orderly liquidation, and forced liquidation.
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 of 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. Within the oil & gas industry, the operating assets come in many varieties, from oil & gas reserves, industry-specific well-site equipment and midstream assets, and less industry-specific equipment utilized by oilfield service providers.
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 as:2
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” (i.e., 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. The intangible elements of going concern value result from factors such as having a trained workforce, 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:
1. Forecast of Expected Future Cash Flows. Guidance from management can be critical in developing a supportable cash flow forecast. Generally, valuation specialists develop cash flow forecasts for discrete periods that may range from three to ten years, or in the case of upstream companies, the economic life of the company’s reserves. Conceptually, one would forecast discrete cash flows for as many periods as necessary until a stabilized cash flow stream can be anticipated. Due to the opportunity to make broad strategic changes as part of the reorganization process, cash flows from the emerging entity must be projected for the period when the company expects to execute its restructuring and transition plans. Major drivers of the cash flow forecast include projected revenue, gross margins, operating costs and capital expenditure requirements. The historical experience of the petitioner company, as well as information from publicly traded companies operating in similar lines of business, can provide reference points to evaluate each element of the cash flow forecast.
2. Terminal Value. The terminal value captures the value of all cash flows after the discrete forecast period. Terminal value is determined by using assumptions about long-term cash flow growth rate and the discount rate to capitalize cash flow at the end of the forecast period. This means that the model takes the cash flow value for the last discrete year, and then grows it at a constant rate for perpetuity. In some cases, the terminal value may be estimated by applying current or projected market multiples to the projected results in the last discrete year. An average EV/EBITDA of comparable companies, for instance, might be used to find a likely market value of the business at that date. For upstream oil & gas companies, a terminal value is typically not utilized given the finite nature of the underlying resource. Instead, the discrete cash flows are projected for the entire economic life of the reserves.
3. Discount Rate. The discount rate is used to estimate the present value of the forecasted cash flows. Valuation analysts develop a suitable discount rate using assumptions about the costs of equity and debt capital, and the capital structure of the emerging entity. Costs of equity capital are usually estimated by utilizing a build-up method that uses the long-term risk-free rate, equity risk premia, and other industry or company-specific factors as inputs. The cost of debt capital and the likely capital structure may be based on benchmark rates on similar issues and the structures of comparable companies. Overall, the discount rate should reasonably reflect the operational and market risks associated with the expected cash flows of the emerging entity.
The sum of the present values of all the forecasted cash flows, including discrete period cash flows and the terminal value (if appropriate), 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.
Cash Flow Test
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.
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 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.
“Fresh Start” Accounting
Companies emerging from Chapter 11 bankruptcy are required to re-state their balance sheets to conform to the reorganization value and plan.
- On the left side of the balance sheet, emerging companies need to allocate the reorganization value to the various tangible and identifiable intangible assets the post-bankruptcy company owns. To the extent the reorganization value exceeds the sum of the fair value of individual identifiable assets, the balance is recorded as goodwill.
- On the right side of the balance sheet, the claims of creditors are re-stated to conform to the terms of the reorganization 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 of oil & gas companies going through a Chapter 11 restructuring process need to juggle an extraordinary set of additional responsibilities—evaluating alternate strategies, implementing new and difficult business plans, and negotiating with various stakeholders. Given executives’ multitude of other responsibilities, they often decide that it is best to seek help from outside, third party specialists. Valuation specialists can relieve some of the burden from executives by developing the valuation and financial analysis necessary to satisfy the requirements for a reorganization plan to be confirmed by a bankruptcy court. Specialists can also provide useful advice and perspective during the negotiation of the reorganization plan to help the company emerge with the best chance of success.
With years of experience in both oil & gas and in advising companies through the bankruptcy process, 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.
1 Accounting Standards Codification Topic 852, Reorganizations (“ASC 852”). ASC 852-05-8.
2 ASC 852-10-20.