September 01, 2013

Bachrach Clothing, Inc. (“Bachrach”) is a mall-based retailer of men’s apparel. Prior to the sale of Bachrach in 2005, which led to the subject of this proceeding, the company’s stock was owned by Edgar H. Bachrach and his two sisters, Sally B. Robinson and Barbara B. James (collectively, referred to as the “Sellers”). Between 1999 and 2004, the Sellers pursued a sale of the business. Eventually, an investment banker introduced the Sellers to Sun Capital Partners (“Sun”), a private equity firm. The Sellers accepted an offer from Sun on January 12, 2005 that consisted of $4 million in cash and a $4 million subordinated note.

Just a few weeks after joining Bachrach, the new CEO brought in by Sun decided to mark down Bachrach’s inventory by approximately $7 million, or 285% more than was budgeted for markdown during that month. This markdown of Bachrach’s inventory resulted in the company’s borrowing base decreasing from approximately $4.3 million to $1.3 million. Sun also added to Bachrach’s liquidity crunch by assessing the company with a $100,000 quarterly management fee, as well as significant one-time expenses in 2005 (e.g., $800,000 in legal fees related to the Sun purchase of Bachrach, a $1 million charge related to the termination of Bachrach’s long-term incentive plan, and other extraordinary expenses). Initially, Sun announced it would make an additional $5 million investment in Bachrach to address the company’s liquidity issues, but eventually withdrew its funding. These actions led Bachrach to file for Chapter 11 bankruptcy on June 6, 2006 in the United States Bankruptcy Court for the Northern District of Illinois, Eastern Division (the “Court”).

Bachrach’s bankruptcy led the company (the “Plaintiff”) to file a lawsuit against the Sellers to recover the purchase price as a fraudulent conveyance. The Plaintiff argued that Bachrach was insolvent at the time of transfer. Both the Sellers and the Plaintiff hired valuation experts to determine if Bachrach was solvent at the time of the sale to Sun. The most significant disagreement between the experts in this fraudulent conveyance case revolved around the Balance Sheet Test of solvency, which entails a valuation of the business enterprise. Although the experts relied on essentially the same information and employed virtually the same methodology, their conclusions yielded greatly divergent values for Bachrach as of the date of the sale.

Both experts utilized a Discounted Cash Flow (“DCF”) method based on Sun’s projection of Bachrach’s cash flows to arrive at enterprise value. Despite the fact that both experts relied on the same methodology and information, the disparity between their ultimate conclusions of Bachrach’s enterprise value was glaring. The Plaintiff’s expert concluded on an enterprise value range of negative $290,000 to $1.16 million, whereas the Sellers’ expert concluded on a value of a little over $6 million. Although many topics were discussed in the Court’s opinion, the principal factor driving the disparity in concluded value of Bachrach was the experts’ differences in their respective discount rates; with each expert considering the Weighted Average Cost of Capital (“WACC”). The Plaintiff’s expert utilized a WACC of 19.5%, whereas the Sellers’ expert utilized a WACC of 11.0%. In the world of business valuation, this is like the difference between night and day. The main differences in the experts’ WACCs, which resulted in the incongruence in value conclusions were: the appropriate capital structure, the equity risk premium, and the size premium.

Capital Structure

The Plaintiff’s expert relied upon a book1 which utilized the average debt to equity ratios of companies in Bachrach’s industry when selecting the capital structure to use in the WACC. The Plaintiff’s expert argued that, “the sale should be valued as to a hypothetical purchaser, so the average industry capital structure should have been used.” The Sellers’ expert relied upon Bachrach’s actual capital structure, arguing that Bachrach’s actual capital structure is more appropriate than an industry average given Bachrach’s debt was lower than most comparable companies.

Ultimately, the Court sided with the Sellers’ expert on this issue, stating that the Plaintiff’s expert, “erred by plugging in the debt structure of comparable companies, as opposed to Bachrach’s actual capital structure.” While the Court agreed with the expert for the Sellers in this case, it did note that the Plaintiff’s expert “did not back up this claim with any literature and his critique was not explained enough to make sense.” As such, the Court’s opinion that using a company’s actual capital structure in a WACC analysis is not necessarily precedent setting given that the expert using the industry data did not support his case. It is actually quite common within the valuation community to consider the industry average capital structure in a WACC analysis when valuing a controlling interest in a company to a hypothetical buyer. As noted by Shannon P. Pratt, “Financial theory has not yet developed a generally accepted theory for predicting a given company’s capital structure. For this reason, analysts commonly look at the average capital structure of guideline companies as a benchmark for a company’s normal capital structure… If a controlling ownership interest is to be valued and the standard of value is fair market value, an argument can be made that an industry-average capital structure should be used.”2

Typically, several factors need to be considered when selecting the appropriate capital structure in a valuation. Common areas to consider are: the context of the valuation (e.g., control versus minority), the theory that current leverage is less important than the desired future leverage, and the current state of the company and the industry.3 In summary, although there is not one correct way to select an appropriate capital structure, it is important to consider the opinion of the Court in this case and be prepared to defend any assumptions with accepted treatises in bankruptcy court.

Equity Risk Premium

In order to estimate Bachrach’s cost of equity, both experts relied on the Capital Asset Pricing Model (“CAPM”) and selected their equity risk premium from Ibbotson’s Valuation Yearbook (“Ibbotson”). The Plaintiff’s expert utilized an equity risk premium of 7.2%, which was the result of aggregating stock market data stretching back to 1926. The Sellers’ expert selected an equity risk premium of 5.6%, which came from stock market data going back only 50 years. The Plaintiff’s expert argued that the Sellers’ expert did not go back far enough (i.e., to 1926) when computing the equity risk premium. The Sellers’ expert countered by arguing that the shorter period was more appropriate because of the recent international diversification of markets, which would lower equity risk in the more current environment.

The Court appears to have relied heavily on the opinions of Professor Aswath Damodaran (“Damodaran”) when opining on which expert’s equity risk premium was most appropriate, given that both experts quoted Damodaran during this litigation (even though they did not use his opinions directly). In his writings, Damodaran noted there are different schools of thought when it comes to the appropriate historical period to use when estimating the equity risk premium, but recommended a long-term historical equity risk premium of no higher than 5.5%. It was noted by the Sellers’ expert that Damodaran typically argued that the equity risk premium can range from 2.87% to 5.5%, and that Damodaran generally recommended a historical equity risk premium of 4.0%. In consideration of Ibbotson and Damodaran, the Court concluded that, “At a minimum, [the Plaintiff’s expert] overstated the equity risk premium by not selecting the data calculated as geometric averages. Both [experts] used arithmetic mean data, and both overstated the equity risk premium as measured on a historical basis. [The Plaintiff’s expert] overstated it substantially more, however. [The Sellers’ expert’s] equity risk premium is closer to the 4% historical figure recommended by Damodaran and more accurate than [the Plaintiff’s expert].”

The Court’s opinion on this issue is interesting from several perspectives. First, it was interesting that the Court was silent on the valuation experts’ use of the 1994 and 1995 Ibbotson publications. Given that the closing of the transaction was during the beginning of 2005, the data used by both experts to select the equity risk premium was excluding a decade of historical data. Second, it was curious that the Court placed such significant weight on equity risk premiums developed by Damodaran, when it is relatively common practice within the valuation community to rely on Ibbotson data, and both experts cited Ibbotson for their own assumptions. Finally, the Court’s opinion that it is appropriate to utilize a geometric average compared to an arithmetic average when calculating the equity risk premium is intriguing. Ibbotson itself states that the arithmetic average equity risk premium can be demonstrated to be most appropriate when discounting future cash flows. Because CAPM is an additive model in which the cost of capital is the sum of its parts, utilizing an arithmetic average equity risk premium is most relevant.4 As noted by Shannon P. Pratt, use of an arithmetic average is a widely (but not universally) accepted procedure for estimating the equity risk premium.5 In summary, because there are multiple ways to estimate the equity risk premium, it is important to be well prepared to defend your opinions with sound empirical data and a command of the studies that you reference.

Size Premium

The experts in this case agreed that their selected size premiums created the biggest difference between the two valuations. Again, both experts obtained their estimated size risk premium from the same source (Ibbotson), but their conclusions were 9.8% and 4.02% for the Plaintiff and Seller, respectively. The Plaintiff’s expert selected his size premium based on Ibbotson’s 10b category, while the Sellers’ expert relied on Ibbotson’s micro-cap category. Ultimately, the Court opined that the Sellers’ expert’s size premium was more appropriate, due primarily to two factors. First, the Court noted that Ibbotson claims that breaking down a decile lowers the significance of the results. In light of this, the Court argued that, “the data reported in the micro-cap category was more reliable because it contained a larger sample size of small companies.” Second, the Court noted the fact that Damodaran recommended the use of a size premium of 4.0%, given that small cap stocks have earned approximately 4.0% more than large cap stocks over the past few decades. Coupling these two factors, the Court opined that the Plaintiff’s expert’s size premium was not reasonable.

Although the Court’s ultimate opinion on this issue is in line with the general consensus in the valuation community and other recent case law, there are additional reasons why the 10b size category may be problematic. Troubled companies, that essentially trade on their optionality (i.e., as a call option), make up a large portion of the companies included in the 10b category.6 In addition, the 10b data set includes companies that have no sales (e.g., speculative, start-up companies).7 The 10b size category includes companies whose market capitalizations are small because they are speculative or distressed. The purpose of the size premium is to incorporate the increased rate of return that investors demand in small companies (relative to large companies) due to the risks inherent in such an investment. The fact that the 10b data set includes companies that are in fact large by various financial metrics, but that are nonetheless in 10b because they are distressed or speculative, is the basis for criticism in relying on this data to value a financially healthy, but “small” company.8 Based on all of these factors, an expert should be very cautious in utilizing the 10b size category in order to estimate the size premium.

Discounted Cash Flow Method

As mentioned previously, both experts utilized a DCF method and the same projections in determining the value of Bachrach, but ultimately derived values that diverged significantly. The main causes of the disparity between the opposing experts’ values for Bachrach were discount rate inputs, as discussed herein. The Court found the disparity in the experts’ valuation conclusions to be troubling, stating, “It lends credibility to the concept that the DCF method is subject to manipulation and should be validated by other approaches.” The Court reiterated the warning from In re Iridium Operating LLC that, “The DCF methodology has been subject to criticism for its flexibility; a skilled practitioner can come up with just about any value he wants. For this reason, it is important to validate conclusions reached using this methodology by comparing the results obtained when other accepted approaches to valuation are used.”

Conclusion

The bankruptcy case, and the resulting fraudulent conveyance claims, of Bachrach provides insight into several valuation topics that an expert should be aware of in bankruptcy court. When forming its opinions on this matter, the Court considered several industry sources that the experts cited in their work. Although the opinions presented by the Court were not necessarily consistent with the most commonly utilized practices within the valuation community, a valuation expert should consider the fact that the Court in this case relied heavily on industry sources provided by the experts to formulate its opinion. As such, this case highlights the importance of presenting a well-supported analysis with industry treatises.

Perhaps the most compelling item to take away from this case for valuation experts is the Court’s opinion with respect to the results of the DCF method. Despite all of the analysis and debate over the nitty gritty details of the WACC, it is clear, based on the commentary presented within this opinion that the Court was skeptical of the results derived from the use of a DCF method in general. Based thereon, when possible, it is advisable for a valuation expert to corroborate the results implied by the DCF method with other accepted approaches to valuation, real world events, and contemporaneous market data. Ultimately, the Court dismissed the fraudulent conveyance claims given that the Sellers’ expert presented “better reasoned” explanations for his analysis.