Chemtura addresses business appraisals in a volatile economy
In Chemtura, the U.S. Bankruptcy Court for the Southern District of New York issued a lengthy decision confirming the debtors’ reorganization plan under Chapter 11 of the U.S. Bankruptcy Code. Bottom line: The valuation reports offered in the case fell short in their ability to sway the court.
Valuing the debtors
The case involved Chapter 11 petitions filed by Chemtura Corp., a public company, and 27 of its affiliates (collectively, the “debtors”). With operations in the United States and Canada, the debtors produced specialty chemicals and other products sold worldwide.
The debtors and almost all of their creditors supported the reorganization plan, but the equity holders opposed it. Their objection was that the plan — which called for distributions of both cash and stock to most creditors — undervalued the debtors. As a result, they argued, the plan overpaid creditors and underpaid equity holders.
In deciding whether to confirm the reorganization plan, therefore, the critical issue for the court was whether the valuation on which the plan was based fell short of the debtors’ actual total enterprise value (TEV). If it did, the creditors would be overpaid. The court concluded that it did not, and confirmed the plan.
Evaluating the valuators
Several valuation experts — all with investment banking firms — prepared reports, but the court focused primarily on UBS, which prepared the equity committee’s analysis, and Lazard, which prepared the debtors’ analysis. Although each valuation report had its weaknesses, the court reserved its harshest criticism for UBS.
UBS estimated that the debtors’ TEV fell within a range from $2.3 billion to $2.6 billion, with a $2.45 billion midpoint. Lazard’s estimate ranged from $1.9 billion to $2.2 billion, with a midpoint of $2.05 billion (the value on which the plan was based).
Here are the highlights of the court’s valuation conclusions:
- DCF. Both firms assumed continuously increasing growth over a five-year period, relying on admittedly aggressive projections by the debtors’ management. But UBS calculated the debtors’ terminal value based on projected earnings in the final year of the period, while Lazard tried to “normalize” earnings to reflect the cyclical nature of the business.
The court found flaws in Lazard’s methods for capturing cyclicality. But UBS failed to even address the issue, instead calculating terminal value based on a level of earnings the company had never achieved. Although valuators traditionally base terminal value on cash flows in the last projected year, the court found this approach inappropriate given the cyclical nature of the business and the uncertainty of overly aggressive projections in a volatile economy. Thus, UBS’s analysis overstated the debtors’ value.
- Comparable companies. UBS criticized Lazard for excluding DuPont and PPG as comparable companies, but the court agreed with Lazard. Those companies dwarfed the debtors in sales, earnings enterprise value and market capitalization and, therefore, were less risky and traded at higher multiples.
The court also agreed with Lazard’s inclusion of European companies in its analysis, saying UBS was wrong to leave them out. These companies operated in many of the same markets as the debtors did, made similar products, and were subject to similar tax and regulatory regimes. In addition, half the debtors’ revenue came from outside the United States.
- Precedent transactions. Again, the court found Lazard’s analysis to be more sound. Among the errors in UBS’s comparable transactions analysis was that UBS included transactions that predated the financial crisis. Using the Lehman Brothers bankruptcy filing on Sept. 15, 2008, as the cutoff date, the court agreed with Lazard that “advanced economies are fundamentally different today, and that relying on multiples from a time period before the crash is inappropriate.”
The court rejected UBS’s contention that comparable transactions that hadn’t yet closed should be excluded. Given their proximity in time, these deals may be the best comparables available, provided the price is fixed by binding documentation.
Two other factors supported the court’s conclusion that the debtors weren’t undervalued. First, vigorous efforts to market the debtors for sale at a price ranging from $2.2 billion to $2.7 billion failed to yield any offers. Second, the creditors had a strong preference for cash distributions, with the majority electing the minimum level of stock. Had they believed the stock was undervalued, the court said, they would have “snapped it up.”
Why valuation methods matter
The Chemtura decision addresses several significant valuation issues, shedding light on the court’s analysis of valuation methods and assumptions as well as its views on the credibility of valuation experts. To help ensure success in cases involving appraising a business’s value, work with a qualified valuation expert.
Sidebar: The case for independent experts
In the Chemtura case (see main article) the court questioned the credibility of the valuation experts, although it didn’t exclude their testimony. Factors that caused the court to take their opinions “with a grain of salt” included:
- Inconsistencies between trial and deposition testimony,
- Unwillingness to give straight answers on cross-examination,
- Statements indicating bias, and
- Financial incentives in engagement agreements.
The last factor, which took the form of “transaction fees” or “deferred fees” contingent on plan consummation or achievement of distribution targets, gave the experts a financial stake in the outcome. Such arrangements are customary, the court explained, but they “can’t be ignored when investment bankers testify.”
Given the inherent conflict of interest when an advisor with a contingent fee arrangement testifies, it’s advisable in most cases to engage independent experts to opine on critical valuation issues.