Distressed debt guide: Valuing distressed debt

Valuation is at the heart of every investment decision, from liquid investments in performing securities to illiquid investments in distressed securities, and everything in between. The general valuation methodologies for consideration are the same – market, income or cost – but the circumstances faced by and the information available to be used to value the security (and the entity to which it is attached) will dictate the appropriateness of the selected valuation approach.

Within the distressed debt market, there is a broad range of securities that span the liquidity spectrum. During the credit crisis of 2008–09, securities which had been liquid became illiquid. The few transactions that were consummated often occurred under distressed conditions. During this time period, both the print and broadcast media spent a great deal of time focusing on the impact of US generally accepted accounting standards (US GAAP) new fair value accounting pronouncement, SFAS 157 Fair Value Measurements (issued in 2006 and now known as ASC Topic 820) on the pricing of securities, especially debt securities, and the implications of both a distressed market as well as distressed transactions in the context of estimating fair value. While a discourse on fair value accounting rules is not the purpose of this chapter, what is relevant is obtaining a thorough understanding of the analytical constructs used in a fair value analysis.

Although all arguments have not been settled, the regulatory framework did attempt to resolve many of the open fair value questions manifested through the credit crisis. A thorough analytical approach to valuation needs to be adapted based on facts and circumstances surrounding a particular security. Conceptually, the data used and the analysis undertaken should be no different for either investing or financial reporting purposes.

The valuation of a distressed debt security requires significant judgment. Many factors play an important role in the valuation process, including the reason for distress (such as over-leverage, operational issues and dramatic market downturn); status of distress (in bankruptcy, missed interest payments or selling at a significant yield over a risk-free rate); and placement of the distressed security within the capital structure of the entity. All of the aforementioned factors play a role in both the methodologies employed and the inputs to the methodologies in the valuation process. It should be made clear for financial reporting purposes that accounting standards (ASC Topic 820) prohibit valuing a security at a distressed price or at ‘fire-sale’ pricing. Yet it must also be understood that securities are valued for accounting purposes based on what a buyer would pay in an ‘orderly’ transaction. This means that generally, in markets which are distressed or when securities that are not performing are valued or traded, the ‘orderly’ price that a buyer would pay takes into account current market conditions and the facts and circumstances related to the individual security being priced.

The approaches utilised to establish fair value for a security depend on the availability of relevant company-specific and market data. For liquid securities (securities that trade with sufficient volume and frequency), fair value is usually established through trade data on the secondary market. It is up to the investment professional to make an assessment, using the techniques described later in this chapter, to decide whether the value to them is greater than or less than the available price on the relevant exchange or over-the-counter market. For less liquid securities, relevant market data is used to provide context for inputs used in the valuation model. This is typically an income approach, or better known as a discounted cash flow (DCF) model. The income approach requires the estimation of two inputs: expected cash flows (including timing) and an appropriate discount rate to adjust the expected cash flows back to the valuation date.

The genesis of a debt security becoming distressed can result from a variety of factors but the resulting price dynamics are the same – the fair value of a distressed debt security will almost always be at a discount to par. To estimate the value of a distressed security, the process begins with identifying the priority of the security within the distressed company’s capital structure. The absolute priority rule is a key determinant of how investors perceive a company’s various sources of funding and the respective risk applicable to each source of funding within the capital structure of a company.

Whether an indication of distress manifests itself in the trading price of a debt security (if liquid) – a credit rating downgrade or a default or imminent default within the debt structure – in most cases the signs of distress are quite telling. While it may be easy to trace the series of missteps that were taken to arrive at the current condition, what is often more difficult is identifying a path back to recovery while maintaining or maximizing the resulting recovery values for the various holders of securities in the capital structure. At the point of distress, recovery options may be limited. Therefore, each variable, such as the timing of cash flows used in the valuation estimate must be considered with appropriate judgment. The options available to management and owners of securities (which may themselves be distressed) in a company that is distressed can be broken down into the following categories:

1. Organic turnaround: Operations rebound prior to company being forced to restructure

2. Capital raise: Divest assets or operating units, equity offerings or additional debt financings

3. Reorganise: Out-of-court through a debt-to-equity swap or recapitalisation. In-court via bankruptcy

4. Liquidate: An orderly wind down of operations and sale of assets

The ultimate recovery value of a distressed security, given the above scenarios, leads to three potential outcomes: (1) a full recovery of principal and interest; (2) a partial recovery of principal; or (3) no recovery. Of these potential outcomes, the value of the securities falling at either end of the recovery spectrum is often the easiest to estimate. For example, an over-collateralised senior secured bank loan stands little chance of not recovering its face value in bankruptcy, and conversely, holders of common equity of a distressed company are often left with little or no value.

The fair value of a security expected to receive a partial recovery (an ‘impaired security’) is often the most difficult to estimate due to the uncertainty surrounding both a distressed company’s value and the value of the individual security. The impaired security effectively exhibits equity-like properties in many distressed situations; no matter what restructuring mechanism is used, impaired security-holders will typically end up with some form of equity. Consequently, as the value of a distressed company falls, so too will the potential recovery and therefore value of individual securities.

Relative to equity securities, the value of performing fixed income instruments is often simple to estimate as the securities pay a pre-determined rate of interest, with the principal coming due at a set date in the future. Therefore the cash flows are relatively certain while the discount rate can be estimated using relevant market data. When a company enters into a period of distress, the schedule of contractual cash flows may become uncertain for certain securities in the capital structure. While a credit agreement may legally obligate a debtor to make scheduled interest and principal payments, a distressed company has several options available to reduce or extend its financial obligations. These options are often either raising additional capital or reorganising its balance sheet.

Of the options a company has to choose from, they are often directed toward finding a solution by a specified future date. As is often the case, loan covenants, required amortization payments and other obligations (all of which a company in distress will not have the capacity to meet) will force a company either to meet its contractual obligations or to develop a turnaround plan. It is this point in time, when a company can no longer meet its obligations, that is often the catalyst for triggering one or more of a company’s restructuring plans (the ‘restructuring event date’).

A distressed company’s future operations can be divided into two different periods. Prior to distress, holders of securities generally receive all expected contractual cash payments. Once a company becomes distressed, but prior to restructuring, holders of securities may not receive all scheduled interest and principal payments. After a restructuring plan has been implemented, the value of individual securities ultimately will be determined based upon the resulting value of the company and the ability to make future contractual interest and principal payments.

To estimate the value of an impaired security as of the present date, the timing of when a restructuring plan will be implemented as well as the potential outcomes must be evaluated. Additionally, the likelihood of the company avoiding restructuring must also be assessed. In some cases a company’s performance may improve to a point where it is able to meet all financial obligations. Under such scenarios, an operational improvement complemented with certain amendments can increase the likelihood that not only will the company avoid restructuring, but also investors can possibly recover 100 percent of the principal of their investments.

This partial chapter is one of 15 in The Definitive Guide to Distressed Debt and Turnaround Investing: A comprehensive resource for making, managing and exiting investments in distressed companies and their securities, a new book from PEI Media. Edited by Probitas Partners, this guide provides investors and fund managers with valuable tools and practical guides, as well as case studies and best practices. Sample contents and more information on the book are available at www.peimedia.com/books.