2021 was a spectacular year for leverage finance, a once obscure area of the capital markets that has morphed into a stand-alone asset class and money machine for the banks that arrange it. According to S&P Global Market Intelligence, leverage loans issued topped $800 billion with over $600 billion absorbed by institutional investors while high-yield bond issuances exceeded $460 billion. Both totals were records, though a significant amount was used to refinance existing debt.
Solvency opinions may not be top of mind when one considers the big year most private equity and credit funds had in 2021; however, the use of significant leverage to fund acquisitions and dividend recaps creates a contingent liability if the subject company struggles to service its debts. The risk to sponsors, sellers, directors, and new secured lenders is that a bankruptcy court determines a leveraged transaction entailed fraudulent conveyance. If so, a court may seek to ammend the transaction at considerable exposure to those found liable.
Solvency opinions mitigate the risk by addressing two legal concepts: the duty of care (informed decision making by directors) and “adequate consideration” or “reasonably equivalent value” in a corporate transaction.
The Business Judgment Rule, an English case law doctrine followed in the U.S., U.K., Canada and Australia, provides directors with great latitude in running the affairs of a corporation provided directors do not breach one or more of their fiduciary duties of a) loyalty; b) care; and c) to act in good faith. Delaware and other state courts generally will not second guess business decisions as long as the duties are not violated.
However, there are instances when state law prohibits certain actions including the fraudulent transfer of assets to stockholders that would leave a company insolvent. State statues precluding this generally are codified under the Uniform Fraudulent Transfer Act while §548 of the U.S. Bankruptcy Code addresses Federal bankruptcy laws. The concept of unwinding a fraudulent transaction was first codified via the Fraudulent Conveyances Act of 1571 that was enacted by Parliament in England.
U.S. Courts will deem a transaction to be fraudulent if there was a) actual fraud; or b) constructive fraud in which a transaction occurred without adequate consideration. Significant emphasis will be placed on the financial condition of the company before and after the transaction. Courts will examine the three primary tests (four in Delaware) that form the basis for a solvency opinion to determine whether the subject transaction entailed adequate consideration.
Does the fair value of the company’s assets exceed its liabilities after giving effect to the proposed action?
Will the company be able to pay its debts (or refinance them) as they mature?
Will the company be left with inadequate capital?
Does the fair value of the company’s assets exceed its liabilities and surplus to fund the transaction?
A solvency opinion is typically performed by a financial advisor who is independent, meaning the advisor has not arranged financing or provided other services related to the contemplated transaction. The opinion is based upon financial analysis to address the valuation of the corporation and its cash flow potential to assess its debt service capacity.
Also, the opinion is just that—it is an informed opinion. It is not a pseudo statement of fact predicated upon the “known” future performance of the Company. It provides a reasonable perspective concerning the future performance of the Company while neither promising to stakeholders that those projections will be met, nor obligating the Company to meet those projections.
Test 1: The Balance Sheet Test
The balance sheet test asks: Does the fair value and present fair saleable value of the Company’s total assets exceed the Company’s total liabilities, including all identified contingent liabilities?
The balance sheet test is a valuation test in which the value of the company’s liabilities are subtracted not from the assets recorded on the balance sheet, but rather the fair market value of the firm on a total invested capital basis. The value of the firm on a debt-free basis is estimated via traditional valuation methodologies, including Discounted Cash Flow (“DCF”), Guideline Public Company and Guideline Transactions (M&A) Methods. In some instances, the Net Asset Value (“NAV”) Method may be appropriate for certain types of holding companies in which assets can be marked-to-market.
Test 2: The Cash Flow Test
The cash flow test asks: Will the Company be able to pay its liabilities, including any identified contingent liabilities, as they become due or mature?
This question addresses whether projected cash flows are sufficient for debt service. A more nuanced view evaluates the question along three general dimensions:
Revolver Capacity: If financial results approximate the forecast, does the Company have sufficient capacity, relying upon its revolving credit facility if necessary, to manage cash flow needs through each year?
Covenant Violations: Does the projected financial performance imply that the Company will violate covenants of the credit or loan agreement, or the terms of any other credit facility currently in place or under consideration as part of the subject transaction?
Ability to Refinance: Is it likely that the Company will be able to refinance any remaining balance at maturity?
Test 3: The Capital Adequacy Test
The capital adequacy test asks: Does the Company have unreasonably small capital with which to operate the business in which it is engaged, as management has indicated such businesses are now conducted and as management has indicated such businesses are proposed to be conducted following the transaction?
The capital adequacy test is related to the cash flow test. A company may be projected to service its debt as they come due, but a proposed transaction may leave the margin to do so too thin—something many companies discovered this year in which they were able to operate with high leverage as long as business conditions were good.
There is no bright line test for what “unreasonably small capital” means. We typically evaluate this concept based upon pro forma and projected leverage multiples (Debt/EBITDA and EBITDA/Interest Expense) relative to public market comps and rating agency benchmarks. While management’s projections represent a baseline scenario, alternative downside scenarios are constructed to asses the “unreasonably small capital” question in the same way downside scenario analyses are constructed to address the question of whether debts can be paid or refinanced when they come due.
Test 4: The Capital Surplus Test
The capital surplus test asks: Does the fair value of the Company’s assets exceed the sum of (a) its total liabilities (including identified contingent liabilities) and (b) its capital (as such capital is calculated pursuant to Section 154 of the Delaware General Corporation Law)?
The capital surplus test replicates the valuation analysis prescribed under the balance sheet test, but also includes the Company’s capital in the subtrahend.
Section 154 of the Delaware General Corporation Law defines statutory capital as (a) the par value of the stock; or in stances when there is no par value as (b) the entire consideration received for the issuance of the stock. Capital as defined here is nuanced. Often it may be a small amount if par is some nominal amount such as a penny a share, but that may not always be the case. What is excluded is retained earnings (or deficit) from the equity account.
The Mosaic of Solvency
The tests described above are straightforward. Sometimes proposed transactions are straightforward regarding solvency, but often it is less clear—especially when the subject company operates in a cyclical industry. Every solvency analysis is unique to the subject transaction and company under review and requires an objective perspective to address the solvency issue.
Mercer Capital renders solvency opinions on behalf of private equity, independent committees, lenders, and other stakeholders that are contemplating a transaction in which a significant amount of debt is assumed to fund shareholder dividends, an LBO, acquisition or other such transaction that materially levers the company’s capital structure.
Originally featured in Mercer Capital's Portfolio Valuation Newsletter: First Quarter 2022