Distressed Valuation

We were engaged to carry out a business valuation on a going-concern, enterprise value basis to support creditors' decisions in planned debtor-in-possession proceedings after insolvency proceedings had opened. The objective was first to assess the various recovery scenarios independently, including continuation of the business by its existing owners, and then to compare their relative attractiveness.

Valuing an insolvent business involves several distinctive considerations. First, the analysis must partly look beyond the company's current circumstances because it is the prospect of continued operations, which is not yet assured, that is being valued. However, existing insolvency issues cannot be disregarded entirely. Even if the business continues, indirect insolvency risks may remain, such as adverse stakeholder reactions to its history. Key employees may prefer to work for a company without that history, while customers or suppliers may withdraw or demand more favourable terms. Second, the analysis must initially set aside the current capital structure, because the allocation of enterprise value among the different providers of capital will emerge only from the analysis, valuation and subsequent negotiations. Third, a valuation in this special situation cannot rely on stable historical conditions, making forecasting particularly challenging. Fourth, uncertainty over the implementation of restructuring measures adds further forecasting risk. Finally, even when the immediate threat of insolvency has passed, the risk profile will generally remain different from that of a financially healthy company. This also makes the use of healthy peers as comparators challenging.

The result was a decision model enabling creditors to assess the value and risks of continuing the business while retaining the existing legal entity.

In mid-March 2020, only a few weeks after the outbreak of coronavirus, investors engaged us to value a major aviation and airline business. International and domestic restrictions on transport and movement had caused its revenue to disappear within weeks. The investors wanted to understand the company's fundamental value at that time.

The assignment encompassed almost the full complexity, and intellectual appeal, of modern business valuation. For the cash flow forecasts, we had to develop future scenarios without resorting to speculation, assess the reliability of the available information, estimate probabilities for different outcomes as objectively as possible, identify interactions and asymmetries between cash flow components, including adverse stakeholder behaviour, and stress-test extreme outcomes. On the financing side, we had to assess the rapidly changing international support measures, anticipate banks' behaviour and perform further stress tests. The cost of capital raised additional questions: how forward-looking were historical risk parameters such as betas, how was the equity risk premium evolving in the early stages of the pandemic, and did the CAPM provide an appropriate benchmark for the cost of capital, or were additional risk factors required? We also had to address negative cash flows and the effects of increased debt risk on the cost of capital relationships.

Time pressure added to the challenge. Events were unfolding rapidly and all parties were extremely anxious. The resulting decision model enabled investors to derive plausible valuation ranges based on our assessment and to see the value implications of their own expectations. We continued developing and updating the model until mid-2022. Our ongoing valuation support ended only when economic conditions had normalised.

We shared some of the findings from this and similar projects with the valuation community at an early stage. The relevant publications and presentations are listed below.