The Valuation of

Distressed Businesses

Establishing a Framework and

Avoiding Pitfalls

The Valuation of

Distressed Businesses

Moderator: Grant W. Newton

Panelists: Teri L. Stratton

Paul N. Shields

Key Points to Establishing a Framework and

Avoiding Pitfalls

• Proper assessment of the turnaround thesis viability and

cash flow projections

• Proper consideration of the capital structure

• Proper development of an appropriate discount rate

• Proper development of market multiples

Can the Company be Reorganized?

• Viability of turnaround thesis

• Management team execution capability

• Build up of projections consistent with turnaround thesis

– Reasonableness, conservatism, milestones

• Adequate liquidity through reorganization

Determinants of Capital Structure and Ability

to Reorganize

• Trade off between interest tax shields and the cost of

financial distress

• The pecking order of financing choices

• The benefits and costs of financial slack

Factors that May Impact the Costs of Financial

Distress, and a Company’s Ability to Reorganize

• Level of operating profits

• Company size

• Nature of assets

• Complexity of capital structure and make up of creditors

• Impact of economic cycles

• Length of revenue cycle

• Average product/service transaction size

• Quality and timeliness of financial reporting

• Leadership and human capital

• Labor relations

• Asset specificity

• Supplier concentration

• Quantity (number and dollar amount) of executory contracts

Tax Considerations• Net operating losses

– Age of net operating losses

– Potential restrictions on utilization of net operating losses• IRC Section 382

• Built in gains/losses

• Special bankruptcy exceptions

• Cancellation of debt (COD) income– Tax attribute reduction

– Taxation of COD income

• Tax basis and holding period– Transaction type

• Character of income– Asset type

• Other tax consequences of debt restructuring and asset foreclosures– Original issue discount (OID)

– Recourse vs. nonrecourse debt

• Consolidated corporate group issues

• Value of tax shields implicit in the weighted average cost of capital (WACC)

Capital Structure for Valuation

• Using different capital structures of debt and equity can

affect valuation

• Options:

– Actual or anticipated at close of transaction

– Industry average

– Theoretical or optimal

Determining Theoretical Capital Structure

• Debt capacity analysis

• Theoretical bond ratings analysis

• Comparable company analysis

• Triangulate appropriate theoretical capital structure

Discount Rates

• Cost of equity

– Modified CAPM

– Duff & Phelps

– Fama & French Three Factor Model

– Consideration of company specific risk

• Cost of debt

– Bond rating and yield to maturity

• Weighted average cost of capital (WACC)

– Value of tax shields implicit in WACC

Comparable Company Multiple Analysis

• Multiples largely move up and down with the economic

cycle

• Also driven by availability of capital, therefore, consistent

with trends of leverage multiples

Distressed vs. Healthy Valuation Multiples

Note: Data points are based on the median; Data for 2008 and 2013 was unavailable

0.0x

4.3x

1.3x

2.5x

5.8x

0.0x

6.8x

8.0x7.7x

7.4x 7.4x

8.7x

12.9x

8.2x

0.0x

1.0x

2.0x

3.0x

4.0x

5.0x

6.0x

0.0x

2.0x

4.0x

6.0x

8.0x

10.0x

12.0x

14.0x

2008

2009

2010

2011

2012

2013

2014

Lev

erage

Rati

os

Tra

nsa

ctio

n M

ult

iple

s

Distressed Deal Multiples (Restaurants)

Non-Distressed Deal Multiples (Restaurants)

Leverage Ratios (Restaurants)

Leverage Ratios (Industry-Wide)