In the summer of last year, the Corporate Insolvency and Governance Act 2020 (CIGA) was rushed through the UK Parliament in a five-week period to deal with the expected fallout from the Covid-19 pandemic. As the biggest change to the UK’s insolvency and restructuring legalisation in over 20 years, one of the cornerstones of this new legislation is the introduction of the Restructuring Plan. While many of the provisions and the intent of both the Restructuring Plan and the existing Scheme of Arrangement are not dissimilar, what is ground-breaking is the introduction of the Cross-Class Cram-Down mechanism (or CCCD) and the sharp focus this is bringing on evidence as to where value breaks within the capital structure of the company in question.
Why is ‘value’ now so important to the provisions of CIGA?
Unlike a Scheme of Arrangement, CIGA allows the Restructuring Plan to be imposed on a dissenting class of creditors or shareholders, effectively introducing the concept of a CCCD, which enables the compromise of the rights of this dissenting class without its consent. While a Scheme requires the support of 75% by value and 50% by the number of each class of affected creditors, the Restructuring Plan requires only the support of 75% by value of creditors in each class who vote. Under the Restructuring Plan, if the consent of all classes of creditor cannot be secured the court can be asked to sanction the Scheme and invoke the CCCD.
Again, in contrast to a Scheme, under the Restructuring Plan, a creditor can be compromised but excluded from voting on the Restructuring Plan if the requisite valuation evidence demonstrates that it is ‘out of the money’.
Before the court can sanction a CCCD, it must consider and satisfy itself as to two conditions:
a) whether any dissenting classes would be any ‘worse off’ with reference to what CIGA terms the ‘relevant alternative’, effectively the most likely event were the Restructuring Plan not ‘sanctioned’; and
b) whether the Restructuring Plan has been approved by at least one class of creditors who would have a ‘genuine’ economic interest in the company under the ‘relevant alternative’ scenario.
‘Breaking up a company to access value is, generally speaking, likely to result in a worst-case outcome for creditors in most instances.’
Martin Drummond, Alvarez & Marsal
The requisite valuation evidence for determining whether a creditor is out of the money (and can therefore be excluded from voting on the plan) – and also in demonstrating that a creditor will be ‘no worse off’ under the Restructuring Plan compared to the relevant alternative – must be presented at both the creditor’s meetings and the hearing at which the court is asked to sanction the Restructuring Plan.
How will the value of the ‘relevant alternative’ be assessed?
While in the past there was a tendency to rely upon an insolvent wind down of the business as the relevant alternative scenario business when implementing a Scheme of Arrangement in the UK, breaking up a company to access value is, generally speaking, likely to result in a worst-case outcome for creditors in most instances. Provided there is a sufficient cash runway, a sale of the going concern (in whole or in part) is now more likely to be determined as the ‘relevant alternative’ (where considered a viable option) given it is clearly in the interests of the dissenting creditors to optimise value when contesting the Restructuring Plan.
Although the relevant alternative and the supporting valuation evidence is yet to be tested in any great depth in the UK courts, it is perhaps inevitable that the inherent subjectivity in any valuation process will result in challenges to the Restructuring Plan by the dissenting parties, which will require the court to consider multiple valuations and scenarios.
This is further complicated by the fact that each distressed business will face a set of unique circumstances that will affect its value. The timescale dictated by the cash runway will be particularly critical – the accelerated sale of a business in a matter of weeks as opposed to an orderly sale following proper market testing will likely lead to very different opinions on value. Other circumstances, such as illiquid or inactive markets (by sector, geography or for certain types of asset classes) may also detrimentally impact value.
Whatever the chosen alternative, the need for objective judgement and observable evidence of the distress discounts applicable on an accelerated sale of a business, or on the realisation of the tangible and intangible asset base on liquidation, will be fundamental to the outcome of the process.
How will value created under the Restructuring Plan be assessed?
If the court is satisfied that the two CCCD conditions have been met, it also needs to conclude that the Restructuring Plan is ‘just and equitable’ before it will consider sanctioning a plan which requires a CCCD. One area the courts will likely consider in assessing the fairness of a Restructuring Plan is how any value or benefits created by the implementation of the Restructuring Plan (often referred to as the ‘restructuring surplus’) will be shared among the company’s stakeholders.
It is therefore important that the value of the entity is assessed with reference to the proposed turnaround plan and Restructuring Plan – including any recapitalisation or refinancing of the business – and not budgets or forecasts which pre-date the resolution of the distress. In order to undertake a meaningful valuation analysis, these projections will need to explicitly incorporate the time it will take the business to return to normal operations. More often than not, a three-year plan (and ideally longer) will be required to adequately capture a company’s full recovery.
Discounted Cash Flow (DCF) analysis, which measures the net present value of free cash flows to the firm or to equity holders, will undoubtedly be the methodology of choice in assessing the value created under the Restructuring Plan, particularly as market volatility since the advent of the pandemic and a collapse in near-term profitability has made earnings multiples analysis largely irrelevant.
DCF is perfectly suited to the valuation of distressed businesses as it can explicitly assess the costs, losses and timeframe required in getting any business back on track. It also provides considerable flexibility and the consideration of multiple scenarios, including stress testing of assumptions and different business plan cases within the Restructuring Plan.
A valuer should not lose sight of the commercial reality
Paramount to any DCF valuation is the extent to which the risks and uncertainties of any turnaround are implicitly captured in the forecasts, or whether the cost of capital (or discount rate) needs to be adjusted accordingly. In an ideal world, the forecasts should reflect as much risk as can be reasonably forecast and modelled.
‘DCF is perfectly suited to the valuation of distressed businesses as it can explicitly assess the costs, losses and timeframe required in getting any business back on track.’ Martin Drummond, Alvarez & Marsal
Yet valuation is only ever as good as the quality of information upon which it is based, and the unprecedented nature of the pandemic and the uncertainty as to when ‘things will get back to normal’ has only made the whole exercise that much more difficult. DCF is dependent on the assumption that a business will continue as a going concern into perpetuity (as captured in the terminal value or exit multiple calculation) so, to the extent that a business quickly deviates from a turnaround plan, any further deterioration of the creditworthiness of the business and higher costs of funding could result in a downward spiral of value destruction in very short order.
DCF analysis can also quickly become an overly theoretical and technical exercise and it is important not to lose sight of the market and the prospective buyers of the business in question. There may be a very small number of buyers with the appetite and the ability to move quickly in these types of distressed situations – which the buyers themselves will likely be aware of – and this lack of competitive tension can squeeze valuations ever further. This market overlay is particularly critical when assessing the value of the ‘relevant alternative’ to the Restructuring Plan.
Practical considerations of valuation under CIGA
The introduction of the Restructuring Plan means, at a practical level, that the valuation process will need to be very front of mind in these types of distressed situations – the swift appointment of an independent valuer with the requisite technical and sector knowledge therefore will be key. Where the valuation is likely to be particularly contentious, it is possible that a number of independent valuers are separately appointed by the relevant stakeholders, so that the company and each class of creditor are all appropriately represented.
However, robust valuation analysis, of a quality that is able to withstand court and stakeholder scrutiny, does not happen overnight. The courts are looking for independent, objective advice which only comes through a deep understanding of the forecasts, the business, and the sector in which it operates.
Specifically, the valuation of large, multinational groups – which may have a spiderweb of intercompany loans and cross shareholdings – can be particularly complex, as in many instances understanding where value lies can only be assessed using Entity Priority Modelling (EPM). EPM employs a complex financial model to estimate the expected returns to a company’s creditors under certain scenarios, and importantly has been tested in the UK courts on various restructuring cases. In our experience, many equity shareholders believe that they hold an interest in a valuable entity until an EPM, pinpointing value leakage to external stakeholders, proves otherwise.
How can A&M help?
A&M is uniquely positioned to support firms, creditors and shareholders aiming to execute restructuring procedures under the new legislation. As seasoned professionals, we possess the expertise to provide robust valuations of a business under either the Restructuring Plan or relevant alternative scenarios to the standards required by the UK courts. Our bespoke EPM model, which we have developed and evolved over many years, is also market leading and has been tried and tested in court proceedings in the UK and all over the world.
The powerful combination of our valuation experience and A&M’s operational heritage helps private equity, hedge funds, corporates, banks and other financial services companies address valuation issues efficiently and effectively. By combining unique industry knowledge across the firm with deep experience in the accounting, technological, legal and compliance, regulatory and limited partner communities, A&M is uniquely positioned to assist clients in navigating the industry’s perpetual crosscurrents.