In the wake of MF Global Holdings LTD’s bankruptcy, clients, regulators, and creditors are all attempting to untangle the defunct investment company’s financial accounts to determine what remains to be distributed to MF Global’s stakeholders. The billions of dollars lost by MF Global on its investments in European sovereign debt left its clients scrambling to salvage any part of MF Global’s assets to recoup their diminished account balances. But what about the other secured and unsecured creditors of MF Global? How much can they lay claim to and expect to receive? Creditors typically arrive at the same question whenever their interests are in jeopardy as a result of a company’s distressed position. Regardless of contentious litigation in the event of default, creditors should immediately seek advice under these circumstances to determine their own potential loss exposure for making timely and effective decisions.
Distressed companies are businesses that are in risk of, or already have defaulted on their debts. Creditors of a distressed company should know that, although a company may not be making payments on some, or all of its debt requirements, there still may be some value remaining on the instruments they hold.
Just because a company cannot make payments on its debt does not mean the company is entirely worthless. Value is typically tied to the company’s assets. The reason being that assets can be valued exclusive of a company’s capital structure. In other words, assets derive their own values, regardless of any level of debt. Valuing a company’s assets is a standard business valuation technique used by valuation analysts and is particularly useful when valuing distressed companies. Once determined, the valuation analyst can begin measuring the specific components of distressed company debt.
As most stakeholders are aware, creditors have first priority to company assets before any equity holders. Those creditors, however, typically do not hold instruments of equal value. Determining the values of those debt instruments requires assessing several critical financial and non-financial factors, including:
- The number of debt obligations outstanding
- The nature of those claims (secured or unsecured)
- Whether all or some of those claims are in default
- The carrying values (outstanding balance plus accrued interest) of those claims
- Expected pay-off schedules of the defaulted obligations.
Valuation analysts use this data to apply one of two fundamental approaches in valuing distressed company debt.
In reorganization situations, it is common to employ a discounted cash flow approach. Each debt instrument is valued separately based the instrument’s expected pay-off schedule. Cash flows from the pay-off schedule are then discounted to present values using a market rate of interest. The interest rate is derived by analyzing the credit ratings of similar distressed companies. Although this is conceptually sound and it appears straightforward, it can be difficult to apply because most distressed companies are either not paying on their debt obligations entirely, or they are paying so little that they are not even covering the interest charge.
Another approach to valuing the debt of a distressed company is the liquidation approach. This approach starts with the fair market value of a distressed company’s assets and subtracts debt claims based on the superiority of the claims relative to each other. For instance, first lien creditors are repaid in full before second lien creditors, and second lien creditors are paid out before the unsecured creditors. Remaining creditors of the final tranche share equally based on the proportions of their claims. This approach gives creditors a more understandable analysis of their interests based on asset fair market values and their claims’ priorities.
Creditors holding distressed company debt will not always have the same complications (or the publicity) of MF Global’s bankruptcy. Knowing the potential loss exposures of their interests, however, will allow them to make effective and timely decisions. Valuation analysts using sound fundamental approaches can assist in determining the values of these types of interests.
Have questions about how valuing distressed company debt or other business valuation services? Post your question below or contact our Valuation & Litigation Advisory Services Group at 440-449-6800.