On January 19, 2005, after a prolonged downturn in the energy market following the 2001 recession, Mirant Corporation and its related entities (“Mirant” or the “Debtors”) filed a joint Chapter 11 plan of reorganization. Mirant is engaged in the business of producing and marketing electric power in the United Sates, the Caribbean, and the Philippines. Mirant’s domestic operations are throughout the United States, but Mirant’s principal locations are primarily along the east coast. Mirant owns or leases electric generation facilities capable of producing approximately 14,000 megawatts of electric power in the United States, 2,200 megawatts in the Philippines, and over 2,000 megawatts in the Caribbean.
Mirant’s bankruptcy hearings were held in the United States Bankruptcy Court for the Northern District of Texas, Fort Worth Division (the “Court”).1 Given that the valuation hearing in Mirant was one of the longest and most thorough in Chapter 11 bankruptcy history, the process and rulings that were determined in this case are useful in gaining a better understanding of the valuation issues that can arise in a contentious bankruptcy case.
Following Mirant’s bankruptcy filing, two official committees emerged to represent the creditors of Mirant: the “Corp. Committee,” which represented the creditors of Mirant, and the “MAG Committee,” which represented the creditors of Mirant’s second tier subsidiary (i.e., Mirant Americas Generation LLC). Furthermore, a committee was appointed to represent Mirant’s stockholders. The committees each hired experts to present valuations on their behalf during the valuation hearing, which sought to estimate the reorganization value of Mirant. The valuation hearing commenced on April 18, 2005, and continued for 27 days over the following 11 weeks.
All of the valuation experts agreed that there are four primary methods for valuing an energy company: comparable companies, discounted cash flow, comparable transactions, and value per megawatt of capacity. The first three valuation methodologies are traditional methods for valuing virtually any type of business. In contrast, the fourth method would only apply in the valuation of an electric power company. Ultimately, each of the experts, and the Court, agreed that in the valuation of Mirant, the discounted cash flow method (“DCF Method”) and comparable companies method (“Comparable Companies Method”) were the most reliable. Although the Court discussed numerous issues and questioned many aspects of each of the valuations, this article seeks to address the most relevant topics that the Court ruled upon in order to bring to light the issues that a business valuation expert should consider in a bankruptcy proceeding.
With respect to each expert’s projections of Mirant’s future cash flows, the Court noted several concerns with the development of the projections. The Court heard testimony from subject matter experts in the electric power industry that were not valuation professionals. In complex industries, subject matter experts can help to defend or reject management’s projections based on key industry variables. In this case, the Court heard testimony from academics and professionals with over 30 years of experience in the energy industry. The underlying assumptions in the cash flow projections ultimately relied upon the industry knowledge of these very experienced subject matter experts.
Another concern of the Court in this case was the fact that as time passed and new industry projections became available, the experts did not change their opinions or update their assumptions to reflect broken projections. The Court stated that, “Where, as here, new price forecasts for gas have been issued by several specialist organizations, it would be clear error for the Court to ignore the effect on Mirant’s value of this change… It is incumbent upon this Court in valuing Mirant to determine whether or not its value extends to equity to reach its decision using the best, most current information available.” Based on these strong comments, it is clear that if the effective date of a valuation is in the future and new information becomes available, a valuation expert should endeavor to use the most current information that is available in testimony.
Another factor analyzed by the Court was how Mirant’s net operating loss carryforwards (“NOLs”) should be accounted for. One of the experts took the view that the value of the NOLs should be calculated separately from the DCF Method so that the risk of these cash flows could be assessed apart from the business as a whole (i.e., the rate of return (or discount rate) utilized to calculate the present value of the NOL related cash flows should be considered distinctly from the rate of return utilized in valuing the business as a whole). The Court took a different position than this expert, ruling that all the tax attributes of the business should be incorporated in the cash flow forecast utilized in the DCF Method. The Court stated that, “it is not sensible to apply variable discount rates to different elements of those cash flows.”
In addition to discrete period projected cash flows, the Court also weighed in on the selection of an appropriate long-term growth rate. In this regard, the Court stated that, “A company’s growth rate… must exceed inflation for the company to survive.” For this reason, despite the fact that the price of electricity had fallen steadily for years, the Court rejected certain valuation experts’ opinions that the appropriate long-term growth rate for Mirant was only 2%. The Court noted that the trend of decreasing electricity prices could not be expected to continue forever and that improved technology would likely make power companies more efficient, and thus more profitable. Further, given that demand for electricity had been steadily increasing, the Court determined that Mirant’s prospects supported a long-term growth rate of 3%, which includes volume growth and some level of price inflation. This ruling by the Court may imply that if a valuation is done on a going concern basis, the valuation expert should consider both inflationary and volume growth in the long-term growth rate of the business in order to capture the true terminal value of a company, unless there is significant evidence that a reasonable expectation of long-term growth is below inflation.
In assessing a reasonable rate of return that would apply to Mirant in the context of the DCF Method, the Court made decisions on the appropriate cost of equity and cost of debt to incorporate into the weighted average cost of capital (“WACC”). With respect to the cost of debt, the Court put significant weight on the actual debt rates obtained by the Debtors for exit financing. The Court stated that, “Till2 suggests, where possible, using the market to determine the appropriate cost of debt in a Chapter 11 case. As reflected by testimony respecting the exit facility, there is an efficient credit market for borrowing by Chapter 11 debtors. Debtors have canvassed the market, and the exit facility reflects the market cost of borrowing; thus, the exit facility is a fair measure of the proper interest rate to use in the debt component of the WACC.” The Court had further evidence to support its position in this case in that seven potential lenders initially competed to provide exit financing, committing up to $2.35 billion even though the plan of reorganization only required $750 million. This implies that in situations whereby such strong contemporaneous market evidence exists, valuation experts may have minimal room for professional judgment or comparisons to the broader debt market when determining the appropriate cost of debt in the valuation of a debtor.
In assessing the cost of equity to use in the rate of return for Mirant, the Court made a strong statement against the use of market indicators. The Court stated that, “the securities market is not the proper place to test whether claims satisfied through issuance of stock are or are not ‘satisfied’ pursuant to Code § 1129(b)(2)(A) in determining whether existing equity may receive some return in a Chapter 11 case. To use a formula based on the market assessment of risk to determine the return for the equity portion of the WACC would effect adoption by the Court of the market’s assumptions not only respecting Mirant and the merchant energy industry but also the market’s overestimate of the disadvantages and underestimate of the advantages of Chapter 11.” Based on this conclusion, it appears that the Court is stating that the capital markets would tend to undervalue companies in Chapter 11 because of the stigma of bankruptcy, but that valuation experts are not allowed to consider those risks in determining reorganization value upon emergence.
In reviewing the Comparable Companies Methods performed by the experts, the Court made several rulings, including how to choose comparable guideline public companies and then how to choose the appropriate multiple to apply to Mirant. With respect to choosing comparable companies, the Court noted several factors that should be considered. First, companies that are in precarious financial condition should not be utilized as comparables because the market price of that company’s equity may be characterized as an option price, rather than a true reflection of equity value. This is somewhat ironic given that the subject of the valuation in bankruptcy is a company in financial distress. However, as mentioned previously, the determination of reorganization value is meant to present the company on an as-emerged basis, with the benefits of a Chapter 11 cleansing behind it. Some of the other factors that the Court analyzed included relative size, proportion of international business, and the riskiness of countries in which there are foreign operations. The Court spent a considerable amount of time analyzing the proposed comparable companies and making sure that each was within a reasonable range of Mirant with respect to these factors to make the analysis reliable.
In choosing the appropriate multiple to apply in the Comparable Companies Method based on the guideline public companies, the Court stated that, “Using a range of multiples from the comparable companies, the average (generally the median average) multiple is then applied to the valuation subject’s projected EBITDA (adjusted as with the comparables) to arrive at a total enterprise value for the subject.” Despite the Court’s seemingly simple guidance in this regard, it may not always be appropriate to just apply an average multiple to the subject company’s results in order to estimate value. By doing this, the valuation expert is essentially making the assumption that the subject company is completely comparable to the group of guideline public companies (i.e., it is an average company). In the valuation of private companies, this is often not the case. It is important to compare and contrast the subject company with the entire group of guideline companies before determining the appropriate multiple. If the risk and growth characteristics of the subject company are materially different than the guideline companies, the average multiple may not be relevant. This concept is well accepted in valuation literature, and in fact, other courts have ruled that relying on median multiples is inappropriate where differences between the subject company and the guideline public companies exist.3
There were two concepts within the Comparable Companies Method on which the Court disagreed with all of the experts, but ultimately conceded to the experts. First was the idea of weighting the comparable companies based on relative similarities. In this regard, the Court stated that, “the Court is compelled to note that weighting of comparable companies based on their similarity to the subject being valued would seem to have some appeal. The experts whom the Court questioned about this rejected the idea, and the Court therefore will not adopt such an approach; it may be that raising the question here will prove useful in future valuations.” Second was the idea of using an average stock price instead of one from a specific day, particularly given that the goal of the valuation was to estimate what the value would be as of a future date (i.e., at emergence). In this regard, the Court stated that, “The Court again questioned the use of a single day’s closing price for comparable company stocks. It seems to the Court that it would make better sense to factor into valuation comparable companies’ stock prices over a period of time, thus avoiding bringing into valuation metrics temporary instability in stock prices, especially considering that the value being determined is for a date in the future, at which time prices are likely to be different than on June 27th. This suggestion, however, brought, at best, a tepid response... The Court determined to use a single day’s closing price… because the valuation experts all agreed that is a proper methodology.” Given that the Court’s views on these issues made it into the ruling despite all of the experts disagreeing with the concepts raised means that an expert that is before this Court in a future case would likely be advised to at least be aware of these issues, and consider if they have any merit based on the facts and circumstances of the case.
The Mirant Chapter 11 case helps to shed light on some key valuation issues and how they have been handled in the context of bankruptcy proceedings. While every case has specific facts that can affect the outcome and the judge’s views, it is important to understand some of the valuation nuances that exist in a bankruptcy context. Some of the most important differences come down to the premise of value, the ways that reorganization value can differ from Fair Market Value, and what that means for the methods and procedures that a valuation expert must employ.