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While in a\nvery strict sense, the valuation of distressed companies is not different from\nthe valuation of healthy companies from a purely technical point of view, it\nnevertheless offers some special aspects in practical terms. This includes some\nnew perspectives on fundamental analysis (here the so called \u201cindirect\ninsolvency costs\u201d become relevant), some more requirements on accuracy of\ndiscounting techniques (e.g., negative cash flows restrict the analyst\u2019s room\nfor applying hands-on cost of capital calculations) and the necessity to take more\ninto account the non-linearity of the equity value functional. This\nnon-linearity thinking is something that valuation professionals do not like a\nlot, thinking in linear terms is much easier. But what works well for healthy\ncompanies, no longer works for distressed companies. This is why in this blog\narticle I am going to shed some more light on the relevance of this latter\npoint below.<\/p>\n\n\n\n
Starting point of the analysis is a very simplistic view on the different capital positions of a company with limited liability (here only: debt and equity) and their distribution at the \u201cend\u201d of the company\u2019s life. From an economic point of view, there is no real end of the company in its current shape. But from a legal point of view there is: it is the case of insolvency! (Comment: Even if companies today more and more often continue to live on after insolvency, it is a fresh situation from a capital providers\u2019 point of view with a new capital structure and new investors \u2013 that is why for reasons of simplicity we can think of the company having an end-of-life at insolvency here from an equity investors\u2019 point of view). At his end point the value of debt and equity \u2013 each in dependence on the value of total assets, i.e. the enterprise value \u2013 is shown below.<\/p>\n\n\n\n
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![\"\"](\"https:\/\/valuesque.com\/wp-content\/uploads\/sites\/3\/2019\/06\/valueCapital-EnterpriseValue-1024x490.png\")
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This graph\nreads as follows: As long as the enterprise value at the end of the company\u2019s\nlife is lower than or equal to the outstanding debt (point X), the debt capital\nproviders get everything. The equity capital providers get zero (they do not\nfall below zero because of limited liability). This is due to the normal principle\nof seniority of debt. Once the enterprise value exceeds the debt value (i.e.\nsurpasses the point X) the equity capital providers start to participate. At\nthe same time the debt capital providers do not benefit anymore: they got paid\nback the outstanding loan \u2013 and that\u2019s it for them. Now, the higher the\nenterprise value is the more the shareholders get. And for enterprise values\nhigher than debt values, shareholders benefit proportionally. Sounds like great\nnews for shareholders, but to put this graph into context of real world it has\nto be said that usually insolvencies take place somewhere in the region of the\nshaded area \u2013 so equity investors do not benefit a lot in most practically\nrelevant cases.<\/p>\n\n\n\n
When we\nlook at the shapes of the distributions of the two capital positions \u2013 debt and\nequity \u2013 one can see the similarity of them to the shape of financial options\nat expiration. In fact, equity looks like a long call on the enterprise value\nwith the full debt value as the strike. And debt looks like a short put on the\nenterprise value, again with the full debt value as the strike. And this is exactly\nwhat the capital positions are from an economic point of view!<\/p>\n\n\n\n
Hence, when the capital positions are like options on the enterprise value, we can also value them similar to financial options. This is an important finding for the valuation of distressed equity in general \u2013 because as long as insolvency has not taken place we are in a similar position as an option investor BEFORE expiration. So let\u2019s have a look on how the value of a long call looks before expiration.<\/p>\n\n\n\n
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![\"\"](\"https:\/\/valuesque.com\/wp-content\/uploads\/sites\/3\/2019\/06\/slope-delta.png\")
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Now the formerly\nkinked function turns into a smoothly curved function (the dark red one in the\ngraph, with the concrete shape dependent on some parameters such as volatility,\ntime to expiration and risk-free interest rates in a simple Black\/Scholes\nsetting). This function now allows us to draw some important conclusions regarding\nthe value development of distressed equity. Obviously, the closer the company\nis to insolvency and all other things being equal, the less the equity should\nreact to changes in the enterprise value. In terms of option pricing theory\nthis is expressed by the Greek letter \u201cDelta\u201d. The Delta is an indication for\nthe sensitivity of the option (here equity) to changes in the underlying (here\nthe enterprise value). The Delta (tangential line to the value function) is\nlower for the more distressed company A than for the more healthy company B. In\nfact, for very healthy companies the delta equals nearly one, meaning that the\nequity develops in the same way as the enterprise value \u2013 this is linearity as\nwe like it as valuation professionals, but unfortunately this is not what we\ncan see for distressed equity (A).<\/p>\n\n\n\n
All this\nhas some important implications for the valuation of distressed equity (so far\nonly from a theoretical point of view). A certain assessment of developments of\nthe enterprise value do not automatically turn 1:1 into changes of the equity\nvalue (adjusted for the leverage effect). We have to adjust them first for the\nDelta of the equity value (to be clear: we have to adjust debt values as well,\nbut this is not the focus here). Not doing this would lead to an overvaluation\n(in case of positive changes of the enterprise value) or an undervaluation (in\ncase of a negative change in enterprise value).<\/p>\n\n\n\n
To put it\nin concrete terms, while the financial leverage effect helps a lot in case of\nimprovement of the whole situation, it does not help as much as we would expect\nfrom our traditional leverage formulas or Enterprise-to-Equity-Value\ntranslations. And: while the financial leverage seems to have a horrible\nconsequence for the equity value if things in general deteriorate based on our\ntypical leverage formulas, it rather has a much softer consequence in reality. <\/p>\n\n\n\n
The big\nquestion is now whether this nice academic view can also be observed in\npractice or whether it is only a technical exercise without any meaning for our\nvaluation practice. Unfortunately, it is not very easy to check this via a\nbroad empirical study. We simply do not have a lot of assets which are similar\nin general but only differ in terms of insolvency risk. But at least we have\nsome listed assets which qualify for such an analysis. One of this pair of\nassets are the listed Belgian financial institution KBC NV and the also listed\nKBC Ancora NV. KBC Ancora is a holding company whose main purpose is to hold\nroughly 20% of KBC NV. KBC Ancora did not hold any more meaningful assets\nduring our observation period, which is very good for analytical purposes\nbecause so our results are not blurred by value effects of other assets. But\nKBC Ancora is additionally financially levered, meaning it is debt financed\nitself. This means, from an economic point of view KBC Ancora is exposed to the\nleverage of KBC per se PLUS its own leverage. The equity of KBC Ancora\ntherefore carries the same risk as KBC (operating plus financial) PLUS an\nadditional risk from its own capital structure. Or to put it differently, KBC\nAncora is the same as KBC (and follows the same drivers) \u2013 the only difference\nis that it carries a higher insolvency risk than KBC. <\/p>\n\n\n\n
Of course, even\nthis assessment is not perfectly true as there are some value-relevant\ndifferences between both companies. KBC Ancora has a higher tax shield because\nof the additional debt financing (positive), but also has a weaker corporate\ngovernance position (if you are a shareholder of KBC Ancora you cannot vote directly\nthrough to KBC but only indirectly \u2013 and at a non-controlling position \u2013\nmeaning you have much less say in KBC) and a worse cash flow access (with a\nroughly 20% holding KBC Ancora does not have any direct access to the cash\nflows, it has to wait for the dividends paid, meaning that the shareholders\nsuffer from at least a one-period lag of cash flow access). But these effects\nare much more stable than the effect from any changes in the insolvency risk\ndue to changes of the enterprise value, meaning that in a dynamic study they\nonly play a minor role.<\/p>\n\n\n\n
Based on\nour theoretical framework we can now make a prediction on how the two stocks\nshould behave relative one to each other. In the upper graph KBC Ancora would\nrepresent point A, and KBC would represent point B. The presumed lower Delta of\nthe higher insolvency risk position (equity of KBC Ancora NV) should outperform\nthe lower insolvency risk position (equity of KBC NV) in bad times because then\nthe negative change of KBC Ancora\u2019s equity is lower due to its lower Delta.\nSimilarly, in good times the equity of KBC should outperform KBC Ancora\u2019s\nequity because then the positive change of KBC Ancora\u2019s equity is lower due to\nits lower Delta.<\/p>\n\n\n\n
Below we provide an overview of relative stock price developments of KBC Ancora and KBC during the time 2007 to 2015. The first important point is here that on average over time KBC Ancora trades at a discount to KBC. This is due to the aforementioned net negative effects of worse corporate governance and cash flow access which clearly overcompensates the tax shield effect. The second important point is that we measure good-times\/bad-times in terms of the relationship of KBC Ancora\u2019s Gross Asset Value (i.e. the market value of KBC shares held) and Net Asset Value (i.e. the market value of KBC shares held minus net debt). The higher this ratio, the more relevant is the debt position and hence the worse the situation is.<\/p>\n\n\n\n
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![\"\"](\"https:\/\/valuesque.com\/wp-content\/uploads\/sites\/3\/2019\/06\/correlation-coefficient.png\")
<\/figure><\/div>\n\n\n\n<\/p>\n\n\n\n
Looking at\nthe graph, we can see that the observations obviously clearly support our\ntheoretical thinking. The relative stock developments of KBC Ancora and KBC are\nvery well in line with what we expected. In times of bad general development\nKBC Ancora\u2019s discount narrows or even turns into a premium (as has been the\ncase during the financial crisis), and in times of good development it is\nrather KBC which outperforms. This finding clearly emphasises the relevance of\nthinking in non-linear, option-like terms when valuing distressed equity \u2013 not\nonly in theory but also in practice.<\/p>\n\n\n\n
But to be\nfair once again, this development of KBC Ancora and KBC is still quite\nsynthetic. In reality we do not have these largely unblurred comparison\npossibilities when valuing distressed equity. The option-like effects are often\novershadowed by other value relevant developments, such as the already\nmentioned topics of indirect insolvency costs, technical discounting effects\nand so on. But the findings from KBC and KBC Ancora at least highlights how\nimportant it is to take this non-linearity effect into account a lot \u2013 together\nwith other crisis-related valuation aspects \u2013 when valuing distressed equity. <\/p>\n","protected":false},"excerpt":{"rendered":"
On 13 and 14 June 2019, the IVSC-WAVO Global Valuation Conference 2019 took place in Frankfurt in front of a […]<\/p>\n","protected":false},"author":4,"featured_media":54435,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[75,64],"tags":[],"class_list":["post-54429","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-english-contributions","category-veranstaltungen"],"yoast_head":"\n