He shares with us the questions the company and its advisers should be asking themselves, in order to make the best decision for the long-term.
Valuations in the restructuring market
We are currently working on planning projects involving group reorganisations and ensuring that assets are only ever moved at fair value. This is to protect the Directors in their personal capacity and prevent future challenges by creditors. We find that care needs to be taken around the potential tax consequences: do these moves create capital gains tax exposure; how robust are transfer pricing schemes; could someone argue this was a deemed distribution?
We are currently working with one firm on a project where we are required to value certain guarantees provided by an entity – exactly the sort of liability that could be missed from a simple reading of a balance sheet, but fundamentally changes the company value. So a very holistic and broad set of experience and skills are needed to identify the valuation issues, let alone perform the work with a COVID-19 and Brexit backdrop.
We anticipate that the restructuring market will open up properly in the late summer and we expect to be busy with value break analysis i.e. where in the stack of senior or mezzanine debt, or bonds does the value sit and therefore, who bears the brunt of the new money. We also expect to be providing or challenging valuation opinions for pre packs and anticipate litigation – we recently finished working with one set of lawyers on matters connected with the Comet administration and expect more of this type.
When valuations go very wrong, they fail to answer the simple question of “but who will fund this over the short term?” and “who will buy this?”
Valuation methods
The basic valuation methods do not change - including multiples and discounted cash flow - but the ability to apply them sufficiently and reflect the risks in the business and the environment, are substantially different and changes depending on the circumstances. Specifically, it often becomes impossible to apply an EBITDA multiple to the current or forecast profits because they are depressed and not representative (one hopes) of the business in the long term.
When valuations go very wrong, they fail to answer the simple question of “but who will fund this over the short term?” and “who will buy this?” The tax basis of value has always assumed a hypothetical buyer – but in the real world, this does not exist. We worked on Peacock’s administration – now the discounted cash flow valuation would have told you the business was worth X pounds, but when credit insurers lost confidence and pulled, it lost all cash liquidity and collapsed overnight. And there was no buyer for the main business – it was simply not compelling enough.
So the key to any valuation in a restructuring environment is to understand what is going on in the company by trying to answer the following: why have sales or margins collapsed; what is the route back to profitability; how will this be funded; how long does this take and, what is the end game?
How do we determine the probabilities? Well, we have to look at the underlying economic forecasts on the global and local economies, but then overlay the competitiveness and compelling nature of the business we are valuing with a strong lens on the competition and what they are doing.
You also have to sceptically and forensically challenge the forecasts and think about what attributes management and the company have to be success in delivering the turnaround. By this, I mean brands, patents, quality management, a loyal customer base, a pipeline of forward orders, a highly skilled workforce, etc.
We are currently looking at a retailer; the business plan makes certain assumptions about when lockdown ends, and when normal trading resumes. But the plan also has to consider: (i) if its far east supply chain is able to cope, (ii) what the broader UK recession will mean for discretionary consumer spending, (iii) how the shift to online and away from bricks and mortar will continue and where will it settle (iv) how working from home will change demand for formal clothing.
Now no one has a better crystal ball than anyone else and so we often advocate scenario planning where we look at the three/four most likely outturns for the business, taking the risk through ascribing a probability to each scenario. We can run discounted cash flows on each scenario and then probability weight.
How do we determine the probabilities? Well, we have to look at the underlying economic forecasts on the global and local economies, but then overlay the competitiveness and compelling nature of the business we are valuing with a strong lens on the competition and what they are doing. We look at similar companies and their results and the ratings applied to their equity and debt. It requires some common sense. It would seem reasonable that if you entered this period of uncertainty as a market leader, your prospects of survival and thriving on the other side will be greater than a me-too brand. We have to look at management’s experience and understand the strength of their relationship with funders. I worked with RBS Bank many years ago as a junior and was quizzed at length about the quality of management. It’s a very practical reality that it is one thing to have a business plan; it’s another to have the skills to deliver it.
One of the challenges in the restructuring environment is the speed at which the company’s own information tends to change, and usually for the worst.
Of course, there can be reasons to be optimistic – there will be many businesses helped in the long term by COVID-19, as it will take out the low margin businesses and reduce oversupply. Not everyone will have been negatively impacted. We saw this years ago in the UK power market when TXU went into administration and increased the prices for all its competitors.
Changing data
One of the challenges in the restructuring environment is the speed at which the company’s own information tends to change, and usually for the worst. In my experience, management have tried to convince themselves they are ok, and tend to be overly optimistic. When my restructuring colleagues and I revisit the underlying assumptions in the plans they usually need downward adjustments. Then, new trading data comes in and they have revised again (usually downward). The final stage is when management realise that if they need to re-negotiate their own equity positions, that it is in their best interest to now produce overly negative forecasts!
This can be disorientating for a valuer – constantly shifting data – but the key to this is that the valuation is really anchored in what is the new normal in three to five years’ time. What is the business worth then, on a multiple’s bases – and how much will it cost to get there and at what risk. Actually, the valuation impact of short-term fluctuations in the forecast for the next 12 months is probably not as material as you might think. Unless, of course, it informs you of the likely long-term customer retention or margin – i.e. that look ahead to the ‘new normal’.
Finally, as cash is king, how will it fund through the period of uncertainty?
Conclusion
You can’t value a business in a restructuring environment unless you understand it commercially – it sounds very much like a statement of the obvious, but too many desktop valuations might take a sector discount rate or multiple and just apply it to a forecast.
You have to know – why it is facing difficulty, what is the route map out, how will the future world be different (more people working remotely, more online retail, lower job security and discretionary spend), and think about it from the angle of competitors, customers, suppliers, employees. Then, you can start to properly appraise the risk and hence, the value.
Finally, as cash is king, how will it fund through the period of uncertainty? If there is no funding, then it potentially ceases to be a going concern and break up value may be all that is left.
Steve Taylor
M: + 44 7799350262
College House, 17 King Edward Road London HA4 7AE
Steve is the Founding Partner at St James and an experienced restructuring professional and a member of R3 – he worked on the Icelandic Banks, split Northern Rock into Good Bank/Bad Bank, worked on the administration of Cyprus Airways and has recently been part of the team restructuring IKKS and Anya Hindmarch ahead of sale to the Marandi family.
Our aim at St James was to become the first choice for lawyers for valuation advice. I led the valuation practice at EY for many years, but conflicts were making it increasingly difficult to work on cases. I also wanted to deliver more insightful advice in a way that simply does not sit well in the Big 4. This is a trend that is going to continue - senior Big 4 partners moving to boutiques -, because the value proposition to clients is so compelling; clients receive all the partner experience delivered with their sleeves rolled up, without clients paying for the back office.
Our model has proven very successful and the client base covers the restructuring, family, commercial litigation and private client lawyers across all tiers, which shows just how much demand there is for an alternative provider of specialist valuation services.
