The current cycle of Chapter 11 corporate bankruptcies involves many cases where the debtor seeks to achieve a balance-sheet restructuring by converting debt into equity. When consensus cannot be achieved, junior stakeholders (i.e., second lien creditors, unsecured creditors and/or equity) will often contest plan confirmation on the grounds that the proposed plan provides more than 100% recovery to the senior creditors. Valuation plays the central role in these cases. A Southern District of New York bankruptcy judge confirmed the reorganization plan in In re Chemtura over the objection of the Equity Committee and other interested parties.1 The court’s decision is noteworthy because of its extensive valuation analysis.
The Debtors, specialty chemicals company Chemtura Corp. and its affiliates, entered Chapter 11 with liabilities exceeding $1.3 billion. In re Chemtura Corp., No. 09-11233 (REG), slip op. at 3 (Bankr. S.D.N.Y. Oct. 21, 2010). The Debtors sought to fix their balance sheet by converting debt to equity. Under the Debtors’ plan, the reorganized company would have funded debt of only $750 million and creditors would have converted the balance of the existing debt into new equity. Id. at 7-8. The plan was accepted by all creditor classes but rejected by the shareholders. Id. at 9.
To confirm the plan over the shareholders’ dissent, the court had to determine whether the plan was “fair and equitable.” Id. at 1. This standard prohibits, among other things, senior classes from receiving more than payment in full for their claims. The Equity Committee argued that the plan undervalued the Debtors by hundreds of millions of dollars and, accordingly, that the plan could not be confirmed because it would pay senior creditors more than 100% of their claims. Id. Thus, the Debtors’ total enterprise value (“TEV”) was the key issue before the court.
Three valuation experts testified at trial — one each for the Debtors, the Creditors’ Committee and the Equity Committee.2 The Debtors’ expert estimated that TEV was between $1.9 billion and $2.2 billion, with a midpoint of $2.05 billion (the valuation specified in the Debtors’ plan support agreement and the value at which creditors agreed to support the Debtors’ plan). Id. at 11. The Equity Committee’s expert estimated TEV to be between $2.3 billion and $2.6 billion, with a midpoint of $2.45 billion. Id. Both the Debtors’ and Equity Committee’s experts applied three valuation methodologies — Discounted Cash Flow (“DCF”), Comparable Companies and Precedent Transactions. Id. at 11-12.
The Debtors’ and Equity Committee’s experts used similar DCF analyses that relied on management’s projections over a five-year period. Id. at 13-14. The Equity Committee’s expert calculated the terminal value by applying multiples to forecasted EBITDA for the last year of the five-year projection period. Id. at 14. The Debtors’ expert, in contrast, applied multiples to a mid-cycle EBITDAR to control for cyclicality in the Debtors’ industry. Id. The court recognized that using the last year of the forecast period was traditional and, arguably, even the “preferred” method in a “more stable economic environment.” Id. at 27. Here, however, the court found the Equity Committee’s use of final year EBITDA inappropriate in light of the cyclical nature of the Debtors’ business, the current economic uncertainty and the aggressive management forecasts on which the DCF analysis was based. Id.
Comparable Companies Method
Due to the aggressive nature of management’s projections, which cast doubt on the usefulness of the experts’ DCF analyses, the court placed great weight on the Comparable Companies method, which estimates enterprise value based on the value of comparable peer companies. Id. at 28.
Only the Debtors’ expert actually derived a valuation using the Comparable Companies method. The Equity Committee’s expert used this method solely as a “sanity check” for its DCF conclusion. Id. at 22. The court found the Equity Committee’s approach “disappointing” and placed greater reliance on the Debtors’ expert, whose ultimate valuation incorporated the Comparable Companies method. Id. at 28.
The court also criticized the selection of comparable companies by the Equity Committee’s expert. Id. at 29. Specifically, the court disagreed with the decision by the Equity Committee’s expert to exclude another specialty chemical company of similar size to the Debtors, which the court found to be comparable. Id. The court also was particularly critical of the Equity Committee’s expert’s inclusion of two much larger, diverse chemical manufacturers as comparables and exclusion of foreign comparables despite the Debtors’ substantial international sales. Id. at 29-30. Ultimately, the court found the Comparable Companies analysis of the Debtors’ expert to be sound and afforded its conclusions substantial weight. Id. at 30.
Precedent Transactions Method
Both experts used the Precedent Transactions approach — an approach that uses multiples derived from the purchase prices of comparable companies in M&A transactions to value the subject enterprise — although the Equity Committee’s expert used the approach only to confirm the reasonableness of its DCF valuation. Id. at 30. The court concluded that while the Precedent Transactions analysis must be used with “some care” to normalize for extraneous factors, such as control premiums, synergies and bidding contests, it is still helpful to valuation analysis. Id. at 30.
The experts differed as to whether it was appropriate to use transactions before September 15, 2008 (the date of the Lehman Brothers bankruptcy filing and a marker of the “recent financial collapse”). Id. at 31. The court concluded that changes in market conditions from the pre-Lehman era, when readily available financing and higher multiples for M&A transactions prevailed, rendered inappropriate the Equity Committee’s expert’s use of multiples from pre-Lehman transactions. Id. The court also disagreed with the Equity Committee’s expert’s use of an acquisition of a stake in a company that was comparable only to a part of the Debtors’ business and that was acquired by a “white knight” investor that arguably overpaid. Id. at 31-32.
The court further criticized the Equity Committee’s expert’s exclusion of a transaction involving a highly comparable specialty chemicals company because the transaction had not yet closed. Id. at 32. The court found that the transaction was, arguably, the best comparable both in terms of the nature of the company and the timing of the transaction. Id. Noting that the purpose of a valuation analysis is to determine what a willing buyer would pay and what a willing seller would accept, and that definitive documentation had already been executed and the price set, the court found it unpersuasive to exclude the transaction because it had not yet closed. Id.
Marketing Efforts and Creditors’ Preferences as Market Evidence
The court also relied on three sources of “market” evidence as support for the lower valuation conclusion reached by the Debtors’ expert. Id. at 33-36. First, the court noted that the Debtors had cooperated with the Equity Committee’s efforts to market the Debtors, but that no offers were made, either at the valuation levels supported by the Equity Committee’s expert and reflected in presentations to prospective investors, or at any price. Id. at 33-34. Second, none of the members of the Equity Committee were prepared to put their own money into the Debtors at prices reflecting the Equity Committee’s valuation. Id. at 34-35. Third, although most creditors and all bondholders had the right to take their distributions in cash or stock, most elected cash rather than stock in the Debtors, as might be expected if the stock of the Debtors were substantially undervalued. Id. at 35-36. The court found these factors were evidence that the value of the Debtors was not as great as was suggested by the Equity Committee’s expert. Id. at 36.
In evaluating the credibility of the experts, the court found that the compensation structures used for both sides’ experts, though not uncommon, materially and adversely affected their credibility. Id. at 36-40. Under the terms of its engagement, in addition to a monthly fee, the Equity Committee’s expert was to receive a “transaction fee” of 1.25% of all amounts distributed to shareholders between $225 million and $450 million, and 2% of the amount over $450 million. Id. at 37. By giving the Equity Committee’s expert a stake in the valuation fight, the expert’s credibility at trial was undermined. Id. at 37-38. Similarly, the success fees in the compensation arrangements of both the Debtors’ and Creditors’ Committee’s experts gave them a stake in the outcome and also adversely affected their credibility in the eyes of the court. Id. at 38-39.
The court also made adverse credibility findings based on perceived evasiveness of trial testimony and numerous occasions of impeachment based on inconsistent prior deposition testimony. Id. at 37. The court found a pitch by the Equity Committee’s expert in which he promised to “try to be aggressive in valuation” to be unusually strong evidence of bias. Id. Finally, the court cited the failures by both the Equity Committee’s and Debtors’ experts to change the midpoints of their valuations in the face of changed economic circumstances over several months as also negatively affecting their credibility. Id. at 39-40. These credibility findings serve as important reminders about the importance of experienced counsel to retain and prepare valuation experts, and the importance of effective discovery and cross-examination in contested valuation disputes.