Valuation plays a key role in financial restructuring, whether out of court or in Chapter 11. Valuation determines, among other things, the recovery for creditors. Pending that, it is a determinant in obtaining financing and in keeping secured creditors at bay. Failure to give proper weight to macroeconomic factors in fixing valuation may result in overpaying creditors or having insufficient working capital. And the inability to properly explain the inclusion of macroeconomic factors may result in the bankruptcy judge not considering them in determining value.
On top of all this, of course, this year is the COVID-19 pandemic, which presents a unique situation in which macroeconomic factors are so great.
Investors buy financial assets for the expected cash to be generated by the assets. Valuation models attempt to relate value to the level of uncertainty (risk) about and expected growth in these cash flows.
Investors make estimates based upon information available at the time of valuation. As described by New York University’s Stern School of Business, estimates of value can be wrong for various reasons:
- Estimation Uncertainty. Even if information sources are reliable, raw information must be input into models. Mistakes will cause estimation error.
- Firm-specific Uncertainty. A company may do better or worse than expected, and the resulting earnings and cash flows will be very different from estimates.
- Macroeconomic Uncertainty. Even if a firm evolves exactly the way expected, the macroeconomic environment can change in unpredictable ways. Interest rates can go up or down and the economy can do much better or worse than expected. These macroeconomic changes will affect value.
The contribution of each type of risk to the overall risk associated with a valuation can vary across companies. When valuing a mature cyclical or commodity company, it may be macroeconomic uncertainty that is the biggest factor causing actual numbers to deviate from projections. Valuing a startup technology company can expose analysts to far more estimation and firm-specific uncertainty.
According to an article in the University of Pennsylvania Law Review, macroeconomic factors — concerns with large-scale economic factors such as interest rates, unemployment, inflation, and national productivity — refer to the risk inherent to the entire market or market segment. It affects the overall market, not just a particular stock or industry.
When a chapter 11 plan of reorganization is disputed, a bankruptcy judge must determine, among other things, the debtor’s value. Valuation also must be addressed when a secured creditor seeks adequate protection of its claim. In many cases, litigants seek to persuade bankruptcy judges to use arbitrary risk adjustments. The most common of these is the use of “company-specific” premiums that reduce value.
Chief Bankruptcy Judge Honorable Christopher Sontchi (Delaware) states in “Valuation Methodologies: A Judge’s View” that bankruptcy judges have become familiar and comfortable with the discounted cash flow, comparable companies, and comparable transactions methodologies. These methods are often referred to as the “standard” methodologies. Judge Sontchi also has written that bankruptcy judges are inherently suspicious of premiums or adjustments. The concern is that the adjustment is being made to manipulate the valuation to reach a predetermined result.
Adjustments can be a means to skew value in favor of the party seeking the adjustment or premium. At first blush, the inclusion of a macroeconomic factor as a premium or adjustment may be viewed with a jaundiced eye.
COVID-19 presents a unique situation in which macroeconomic factors are so great, the ripple affect so profound, and their impact so extended in time that they should be considered separately from the standard analysis process.
However, COVID-19 presents a unique situation in which macroeconomic factors are so great, the ripple effect so profound, and their impact so extended in time that they should be considered separately from the standard analysis process. This should be done instead of incorporating them into the weighted average cost of capital.
Valuation consultants should not endeavor to be neutral on macroeconomic variables. Bankruptcy courts should give appropriate consideration to macroeconomic factors — whether they result in reducing the value or increasing it.
From the perspective of creditors, too much weight given to macroeconomic factors or assuming that such factors have a longer lifespan than is likely will result in excessive devaluation and reduced recoveries. This requires, among other things, an understanding by the court of the likelihood, nature, and impact of potential governmental action and of citizen actions, for example, on the value initially arrived at using standard methodologies.
In valuation, it is necessary to understand the impact — and the timing — of macroeconomic factors (if any) on expected cash flows and on their present value. These factors should not be incorporated into firm-specific uncertainty by way of an adjustment to the discount rate. Otherwise, it could potentially result in overweighting or multiple counting.
A project’s cash flows initially should be forecast in the absence of macroeconomic factors. The potential impact of macroeconomic factors may burn off over a shorter period of time than the end date for discounting future cash flows without having incorporated a premium for macroeconomic factors. If a premium simply is incorporated into the standard discounted cash flow analysis, the impact of macroeconomic factors will be presumed to affect cash flows after the impact actually has expired. That would artificially reduce value. In other words, a premium for macroeconomic factors may be appropriate for a time period that is less than that used in a traditional discounted cash flow analysis.
It is appropriate for bankruptcy courts to be skeptical of arbitrary add-ons. But, a lesson learned from COVID-19 is that macroeconomic factors now justify much more analysis in the ultimate determination of value. “More analysis” does not automatically equate to a premium. In fact, it may result in a reduction. It warrants a bankruptcy court’s careful consideration and cautious weighing of the impact of such things as:
- Federal Reserve policy and interest rates
- Changes in the macroeconomic environment that lead to or are caused by state and federal regulatory actions
Adjustments, if any, to account for macroeconomic factors should not be made by increasing/decreasing the weighted average cost of capital in performing a discounted cash flow valuation. Rather, after using standard methodologies, macroeconomic factors should be a potential, separate adjustment to the initial overall valuation (which was arrived at using standard methodologies). Doing so enables the court and other parties in interest to see more clearly the valuation impact from macroeconomic factors and justifications for it.
Kenneth A. Rosen is a partner and chair emeritus of the bankruptcy, financial reorganization & creditors’ rights department of Lowenstein Sandler LLP. The views expressed herein are those of the author only and are not necessarily shared by other persons at Lowenstein Sandler. Each case is unique. The law is subject to interpretation.