Vol 7 (2010) - Issue 1

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Valuation Disputes in Restructurings: More to Come

Introduction

One of the most fundamental questions in any restructuring is what is the value of the underlying business? The tranche of the capital structure in which value ‘breaks’ will determine the likely strategies adopted by the various classes of capital provider to key questions on a restructuring – who will provide any new money requirement?, on what terms? and how can the solution be delivered?

For the most part, the wave of private equity buyouts conducted between 2005 and 2007 involved sound businesses which continue to operate profitably at the operating level (i.e. before interest charges). However, a high proportion of these businesses remain significantly over-leveraged.

Quarter four 2008 saw a double hit to valuations – not only did share prices and other risk assets fall, but the shock to business confidence saw a significant de-stocking/reduction in demand hitting underlying operating profits of many businesses. If valuation is expressed as a multiple of a measure of profits (e.g. EBITDA), then both elements of this valuation equation fell sharply.

As a result, the enterprise value (i.e. the value of the underlying business on a debt free basis) fell sharply, often to a point where the value of equity, mezzanine and junior debt was fundamentally impaired.

The junior creditor perspective

This value break, when coupled with new money requirements, meant that equity and junior debt providers were not prepared to put in new money at their current level within the capital structure.

Rather, offers of new money by private equity or mezzanine houses have often been made on a ‘super senior’ basis i.e. ranking ahead of the existing senior debt.

Alternatively, offers of new money by junior creditors or equity providers have been predicated on the basis of a significant de-leveraging via a write off of senior debt as part of a fundamental balance sheet restructuring. In practice, the reluctance of senior debt providers to take such fundamental write-offs, coupled with the logistical challenges of co-ordinating large, diverse syndicates has often meant that senior debt providers have ended up providing the new liquidity themselves.

With equity market indices up by an average of approximately 60% since the trough in the first half of 2009, a sustained rebound in pricing of risk assets is likely to have a significant impact on ongoing restructurings. The most obvious impact is that value breaks are moving back down the capital structure back towards the mezzanine and equity tranches.

This recent uplift in valuations has impacted behaviour of junior creditors who now perceive that their economic interest has returned and could grow significantly in future. In practice, this has meant a reluctance to ‘hand over the keys' to the senior lenders and a fight to retain potential upside.

'Extend and pretend'

Perhaps the most common theme seen in restructurings in the last year has been the difficulties in executing a fundamental balance sheet restructuring. Instead we have seen a preponderance of temporary solutions, variously called 'sticking plaster' or 'extend and pretend' solutions whereby covenants have been re-set, pricing on senior facilities increased and the term extended. This has often occurred even where the resulting debt structure may not be sustainable longer term, particularly once the interest rate cycle turns up.