Min Shi, Mohammed Khalil and Shreya Gupta, Oxera

This is an extract from the fourth edition of GAR’s The Guide to Damages in International Arbitrations. The whole publication is available here

The covid-19 pandemic has indisputably caused large-scale disruptions to the global economy. The International Monetary Fund expects the global economy to contract by 4.9 per cent in real terms in 2020,  the European Central Bank forecasts a recession of 8 per cent in the eurozone  and the World Bank forecasts there to be the deepest global recession since the Second World War. 

In response, many governments have introduced measures to reduce job losses and to mitigate the losses suffered by businesses as a result of lower consumer demand and government-mandated lockdowns (and other restrictions on movement). For example, since the pandemic was declared in March 2020, the European Commission has approved approximately €3 trillion in state aid to deal with the effects of covid-19.  In the United Kingdom, as at the beginning of May 2020, salaries for more than six million workers were covered by the national furlough scheme. 

Many companies have also suffered losses as a result of the actions of other companies. Take, for instance, Boeing’s decision to walk away from a multibillion-dollar deal with Embraer after two years of negotiations, with both companies now in dispute about Boeing’s alleged breach and Embraer’s alleged losses.  Similarly, the conglomerate LVMH’s aborted acquisition of Tiffany – touted to be the biggest deal in luxury retail – threatened at one point to land both parties in court.  Many more merger and acquisition (M&A) deals have unravelled during the pandemic, driving businesses and their lawyers to scrutinise the contracts for pandemic-related carve-outs and evaluate whether they can invoke the material-adverse-effect clause.

Outside M&A, force majeure-related claims are becoming a hot topic with legal professionals for contracts that were breached or prematurely terminated. Indeed, many legal professionals expect to see a large increase in the number of commercial disputes following the pandemic, with companies that have been negatively affected resorting to litigation or arbitration to seek compensation for damage suffered. 

In this chapter, we set aside the legal question of whether, and the circumstances under which, a violation of contractual terms amid the covid-19 pandemic constitute a breach of contract for which a party is liable for damages. Instead, we discuss the challenges that are likely to arise when quantifying damages using two commonly used methods for financial valuation – the discounted cash flow (DCF) method and the multiples method (i.e., the income-based and market-based methods) – in covid-19 related cases. We focus on the areas that need to be considered carefully to arrive at a robust damages assessment using these methods.

Challenges in applying DCF method to covid-19 related disputes

The DCF method typically estimates damage suffered by a claimant as the difference (in present value (PV) terms) between:

  • the claimant’s cash flows in the counterfactual situation (i.e., without the alleged breach of contract); and
  • the claimant’s cash flows in the actual situation (i.e., with the alleged breach of contract).

The cash flows in the counterfactual and actual situations are then discounted to the relevant valuation date at appropriate discount rates that reflect the time horizon and riskiness of these cash flows. The application of the DCF method to quantify damages is illustrated in Figure 1.

Figure 1: DCF method: damages equal the present value of the difference in cash flows

As shown in Figure 1, the only distinction between the counterfactual and actual situations is the alleged breach and its effect on the claimant’s cash flows. This means that any factors that have the same effect on a claimant’s cash flows both with and without the alleged breach should not affect the quantum of damages.

Considerations for constructing the appropriate counterfactual situation

The construction of an appropriate counterfactual situation and the cash flows in this counterfactual are key to any DCF-based damages assessment. These are often hotly debated between quantum experts working on opposite sides of a dispute.

This construction of an appropriate counterfactual situation is likely to be particularly challenging in covid-19 related disputes. This is because, in many cases, the cash flows of a company are likely to be affected by multiple factors around the same time, making it difficult to isolate the effects of the alleged breach from those of other factors unrelated to the breach.

As an example, consider a chain of Italian restaurants in the United Kingdom suing its supplier of flour and yeast for failing to deliver the contractual amounts of these ingredients, which are key to making its best-selling pizza for both eat-in and home delivery customers, starting in March 2020. The restaurant chain claims that, as a result of this breach, it suffered from lower pizza sales and lower profits.

For simplicity, we assume that the fall in profits in this example results from a combination of the following factors:

  • Factor 1 – a government-imposed lockdown, which has reduced (1) the number of eat-in customers (albeit this is potentially offset, in whole or in part, by an increase in the number of home deliveries), or (2) staff members working in the restaurant.
  • Factor 2 – a deterioration in the economic situation for customers because of job losses or pay cuts, which has reduced its customers’ discretionary spending.
  • Factor 3 – customers who are loyal to the restaurant chain switching from pizza (which is more profitable for the restaurant) to other dishes (which are less profitable) because of the lack of availability of pizza.
  • Factor 4 – customers who are less loyal to the restaurant chain switching from this chain to a competitor because they want to eat pizza.

Factors 1 and 2 are unrelated to the breach (i.e., they would have happened with or without the supplier’s failure to deliver the contractual amounts of flour and yeast). In contrast, Factors 3 and 4 are specifically caused by the alleged breach. These two factors reduced the restaurant chain’s cash flows in the actual situation relative to the counterfactual situation, and thus caused damage to the restaurant chain. As mentioned above, the only distinction between the actual and counterfactual situations is that the latter does not reflect the effects of the breach on the business’s cash flows. Therefore, the appropriate counterfactual situation in this context is one that reflects the lower sales and profits arising from factors unrelated to the breach (i.e., Factors 1 and 2), but not the effects of factors relating to the breach (i.e., Factors 3 and 4).

However, isolating the effects of each factor on the restaurant chain’s cash flows is likely to be challenging, given that all four factors affect the cash flows of the restaurant around the same time, the effects of the factors may be interrelated, and the damages are likely to depend on the chosen valuation date in the quantum assessment.

In an ex ante assessment, damages are assessed as at the date of breach, using the information and evidence available at that point in time. In such an assessment, the quantum expert may construct the counterfactual situation based on the restaurant chain’s pre-covid-19 business plan, adjusted for the expected effects of covid-19 (i.e., Factors 1 and 2, above), based on contemporaneous evidence.

In an ex post assessment, damages are assessed as at the date of award, which is often much later than the date of breach. In such an assessment, the quantum expert would have the benefit of relying on information that reflects the actual effects of the pandemic on the sector in question. For example, the quantum expert may construct the counterfactual situation based on the actual financial performance of the restaurant chain’s competitors, which suffered because of covid-19 (i.e., Factors 1 and 2) but not because of the supplier’s breach (i.e., Factors 3 and 4).

Another complication in assessing the damages in this hypothetical dispute is that other suppliers of the restaurant chain may have also breached their contractual obligations to the chain. For example, the supplier of pepperoni may also have been delayed in supplying the chain with its ingredients. In this situation, the effects of Factors 3 and 4 on the restaurant chain’s profits would also need to be apportioned between the breach of the flour and yeast supplier and the breach of the pepperoni supplier. Tackling this question is likely to require careful economic and financial analysis, and a good understanding of how this industry works.

Considerations for estimating cash flows in the actual situation

Another complication concerns the estimation of the company’s cash flows in the actual situation. While cash flows in these circumstances are generally directly observable relative to those in the counterfactual situation, there is a potential legal and factual question about whether the company has done all that is reasonable to mitigate the effects of the alleged breach.

To illustrate this, assume that there are two near-identical chains of Italian restaurants in the United Kingdom that compete with one another (i.e., they both serve the same type of food in the same price range, the quality of their food is the same, they are located near each other, and their businesses are of the same scale). Assume also that these two restaurant chains were expected to deliver the same financial performance in the absence of the breach by their common flour and yeast supplier.

However, following the supplier’s breach, the first restaurant reacts by investing in and promoting other products that do not rely on flour or yeast (e.g., risotto or aubergine parmigiana), thereby reducing their losses caused by the breach. However, the second restaurant does not react to the supplier’s breach and suffers from larger losses, under the assumption that it would be entitled to recover these damages in future proceedings. Should these two otherwise identical restaurant chains be awarded different damages as a result of the same breach? Although this is predominantly a legal question, it has significant implications for the quantum expert assessing damages based on the DCF method.

Effects of covid-19 on the discount rate

In addition to estimating the appropriate cash flows in the counterfactual and actual situations, it is also important to determine the appropriate discount rate that reflects the riskiness of these cash flows.

In general, the discount rate can be split into two components: a risk-free rate and a risk premium. The risk-free rate reflects the time value of money, whereas the risk premium reflects the uncertainty associated with future cash flows. These two components may move in opposite directions during periods of uncertainty.

  • During the covid-19 pandemic, the risk-free rates fell sharply as part of a ‘flight to quality’, whereby investors move away from risky assets and towards safe assets, such as government bonds and precious metals. This became evident in August 2020, when the yield on 10-year US treasury notes closed at a record low of 0.52 per cent, but the price of an ounce of gold (which is considered a safe asset) exceeded US$2,000 for the first time. 
  • Risk premia may have increased and become more volatile during the pandemic. For instance, Muir (2017) states that risk premia have spiked dramatically in financial crises.  Similarly, Figure 2 below shows how the credit spreads on high-yield corporate bonds increased during both the global financial crisis in 2008 and the covid-19 pandemic.

Figure 2: Historical credit spreads on high-yield corporate bonds

Source: Federal Reserve Bank of St Louis 

Given that risk-free rates and risk premia have moved in different directions during the pandemic, the overall effect on the discount rate is not clear. Therefore, quantum experts assessing damages based on the DCF method would need to robustly estimate the discount rate based on the available empirical evidence for the market and sector in question as at the valuation date.

Challenges in applying multiples method to covid-19 related disputes

The multiples method is based on the principle that two businesses with similar characteristics are worth similar amounts. Applying this method to valuing a company involves three steps, as set out below, and the multiples-based valuation of a company in the counterfactual and actual situations can be compared to arrive at a damages estimate.

  • Comparators – the first step is to identify companies that are comparable to the subject company in terms of the nature of operations, competitive position, risk profile, among other things. This normally involves identifying comparable listed companies or comparable companies that were acquired around the valuation date.
  • Multiples – the second step is to calculate the valuation multiple for each comparable company identified in the step above. One commonly used multiple is the ratio of each comparable company’s enterprise value (EV) relative to its earnings before interest, taxes, depreciation or amortisation (EBITDA), which is often a good proxy for a company’s operating cash flows. 
  • Valuation – the third step is to multiply the median (or mean) of the multiple of the comparable companies obtained in the step above (e.g., the EV/EBITDA multiple) by the relevant measure of the subject company (e.g., the EBITDA of the subject company) to value the subject company.

In general, there are two key elements in a robust application of the multiples method. The first is to ensure that the EBITDA estimates used in this analysis reflect the company’s long-term steady-state level of profitability, also known as ‘normalised earnings’. The second is to ensure the consistency of the valuation multiples of the comparable companies and the subject company. For example, if the EV/EBITDA multiple is calculated based on a sample of relatively mature companies in a given sector, this multiple should not be applied to the EBITDA of a company in its early stage of development in this sector.  However, applying the multiples-based method to valuing companies amid the covid-19 pandemic is likely to present some practical challenges.

An initial challenge is to ensure that the effects of the pandemic are not double counted in the valuation of the company. Double counting occurs when a covid-infected multiple (pun intended) is applied to a company’s earnings in 2020, which are also likely to be heavily affected by covid-19. For reasons described below, both the EBITDA and multiples estimated during the pandemic are subject to a number of issues and are unlikely to be indicative of long-term financial performance. Therefore, if the depressed multiple is applied to the subject company’s depressed profit metric, the impact of covid-19 will effectively be double-counted, resulting in a distorted valuation of the company.

Second, estimating the company’s long-term steady-state EBITDA is challenging, not least because the EBITDAs of many companies during the pandemic may not reflect those companies’ long-term steady-state levels of profitability. Interestingly, some companies have started reporting a variation of EBITDA, termed EBITDAC (earnings before interest, tax, depreciation, amortisation and coronavirus), which strips out the effects of the pandemic on their EBITDA.  If this is estimated correctly, it could be used as a starting point to assess the subject company’s normalised level of EBITDA. However, if this approach is taken, it will be important to ensure that the effects of the pandemic are reflected separately in the valuation of the company.

Third, applying the appropriate multiple to the normalised level of EBITDA for the subject company in an internally consistent manner is complex. On one hand, it is questionable that estimates of multiples that are based on information before the pandemic should be applied to EBITDA levels observed during the pandemic. On the other hand, multiples estimated using information during the pandemic may not yield a robust estimate of a company’s value. For example, in March 2020, market capitalisations of most companies fell dramatically because of the uncertainty created by covid-19. Consequently, backward-looking multiples (defined as the value of a company relative to its earnings in the previous year) declined for a large number of industries, since the effects of covid-19 were not reflected in the historical earnings used to determine these multiples. Similarly, forward-looking multiples (i.e., multiples defined relative to a company’s expected future earnings) may not necessarily offer a solution since many companies stopped issuing earnings guidance during the height of the pandemic in spring and summer 2020. In addition, the high degree of uncertainty is likely to cause market capitalisations to be highly sensitive to new information, which would result in multiples that are highly volatile.

A further challenge is that the pandemic may affect the multiples of previously comparable companies differently. As discussed above, the multiples method relies on the appropriate identification of comparable companies, based on industry, location, size, among other things. However, companies with otherwise similar characteristics may display different levels of resilience to the pandemic. For example, a company may have greater online presence relative to others operating in the same industry, thereby mitigating the effects of the pandemic on that specific company. This would result in a multiple that is not in line with those of otherwise comparable companies. This means it is important to examine the effects of covid-19 on individual companies, rather than adopting a ‘one-size-fits-all’ approach.

Potential DCF-multiples hybrid approach

One potential way to get around some of the problems discussed above is to value the company as the sum of its value during the pandemic and after the pandemic period, using the following steps.

  • For the period during the pandemic, one could value the company by estimating the expected cash flows and discounting them to the present time using the appropriate discount rate. This is similar to the approach set out, above, for the DCF method.
  • For the post-pandemic period, one could value the company by applying the historical multiples (or adjusted historical multiples if there is evidence that the future multiples are likely to be different from the historical ones) to the relevant metrics of the subject company in the year it is expected to reach a steady-state level of profitability.
  • The current value of this company would be the sum of the present value of (1) the estimated interim cash flows during the pandemic, and (2) the estimated multiples-based terminal value of the company in the post-pandemic period.

Implementing the above approach is not straightforward: it requires an estimation of when the pandemic period will end, a reliable estimation of the subject company’s cash flows during the pandemic period, and an appropriate valuation multiple in the post-pandemic period.

Looking forward

As businesses look at ways to bounce back following the unprecedented effects of the covid-19 pandemic, companies and investors are likely to explore legal options to claim damages from parties that have allegedly breached their contractual obligations.

At that point, quantum experts would need to think carefully about how best to tailor the commonly used valuation techniques to robustly quantify damages in disputes relating to covid-19. It is more important than ever to ensure that the quantum assessment is based on sound economics and finance theory, and that it is consistent with contemporaneous empirical evidence.

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