Weighing COVID-19 (and Other Macro Factors) in Bankruptcy Valuations

By Kenneth A Rosen

In the realm of financial restructuring, the pivotal role of valuation cannot be overstated. Whether orchestrating an out-of-court workout or navigating the intricacies of Chapter 11, the determination of a company's worth influences creditor recovery, facilitates financing, and maintains a delicate balance with secured creditors. However, failure to appropriately consider macroeconomic factors in this valuation process can lead to overpayment of creditors or a shortage of working capital, with potential ramifications on the overall restructuring strategy. The current backdrop is further complicated by the unprecedented challenges posed by the ongoing COVID-19 pandemic, intensifying the impact of macroeconomic factors. This article explores the critical nuances of weighing these factors in bankruptcy valuations, emphasizing the need for a meticulous and informed approach.

Valuation Basics:

At its core, valuation involves predicting the expected cash flows generated by financial assets. Yet, as outlined by New York University's Stern School of Business, the accuracy of these predictions can be compromised by various uncertainties. Estimation errors, firm-specific uncertainties, and macroeconomic uncertainties all contribute to the complex landscape of valuation. Investors, armed with estimates based on available information, navigate this terrain, understanding that even the most reliable information sources may succumb to estimation errors.

Macroeconomic Factors:

A Market-Level Influence: Macroeconomic factors, encompassing elements like interest rates, unemployment, inflation, and national productivity, introduce market-level risks that transcend individual stocks or industries. The University of Pennsylvania Law Review identifies these factors as inherent risks affecting the overall market or specific market segments. In the context of bankruptcy, where a judge must ascertain a debtor's value during a chapter 11 reorganization, macroeconomic factors play a pivotal role. However, the challenge lies in convincing the court to consider these factors as legitimate contributors to valuation, particularly when litigants may advocate for arbitrary risk adjustments.

Judicial Perspective on Valuation Methodologies: Chief Bankruptcy Judge Christopher Sontchi (Delaware) highlights the prevailing skepticism among bankruptcy judges towards adjustments or premiums. This skepticism stems from concerns that adjustments might be employed to manipulate valuations. Despite the judiciary's familiarity with standard methodologies like discounted cash flow, comparable companies, and comparable transactions, the inclusion of premiums remains contentious. The article suggests that such premiums, especially those associated with macroeconomic factors, should be subject to careful scrutiny rather than outright dismissal.

Unique Considerations Amid the COVID-19 Pandemic:

The article acknowledges the unique circumstances presented by the COVID-19 pandemic, where macroeconomic factors exhibit an unprecedented magnitude, profound ripple effects, and an extended timeframe of impact. In such cases, the customary incorporation of these factors into the weighted average cost of capital might not be sufficient. The article advocates for a separate consideration of macroeconomic factors in the valuation process, distinct from standard methodologies.

Avoiding Arbitrary Add-ons:

While cautioning against arbitrary add-ons, the article stresses the need for heightened analysis of macroeconomic factors in the determination of value. Drawing lessons from the pandemic, it underscores that this "more analysis" does not automatically translate into a premium; instead, it calls for a nuanced evaluation of factors such as Federal Reserve policy, interest rates, and regulatory actions. Adjustments should be made cautiously, not by altering the weighted average cost of capital, but as a potential separate adjustment to the initial overall valuation derived from standard methodologies.

In the complex landscape of financial restructuring, the article concludes by advocating for a judicious approach to weighing macroeconomic factors in bankruptcy valuations. Acknowledging the skepticism surrounding arbitrary adjustments, it highlights the imperative of conducting thorough analyses, especially in extraordinary circumstances like the COVID-19 pandemic. By urging bankruptcy courts to carefully consider the impact of macroeconomic variables, the article aims to foster a more informed and transparent valuation process, ensuring that the true value of distressed assets is comprehensively and fairly assessed.