On March 18, 2009, Chemtura Corp. and 27 of its affiliates (“Chemtura” or the “Debtors”) filed chapter 11 petitions in the United States Bankruptcy Court for the Southern District of New York (the “Bankruptcy Court”). The Debtors produce specialty chemicals, polymer products, crop protection chemicals, and pool and spa chemicals. Chemtura has operations in the United States and Canada and holds direct and indirect interests in more than 140 nondebtor affiliates worldwide.
On October 21, 2010, Judge Gerber issued a lengthy decision on the confirmation of the Debtors’ plan to emerge from bankruptcy. The plan was supported by virtually all of the creditors, but was strongly opposed by the equity holders. The primary objection to confirmation was that the distributions to bondholders and most other creditors, which included cash and stock, undervalued the Debtors, leaving equity with too small of a recovery. Given that the primary topic at issue in this case was the value of the Debtors around which the plan of reorganization was based, the majority of Judge Gerber’s decision focused on his evaluation of the financial experts that provided testimony on the valuation of the Debtors. In addition, Judge Gerber discussed his views on the credibility of the valuation experts given their roles and fee structures with their clients.
The most critical argument in this highly contested matter was the determination of the enterprise value (“EV”) of Chemtura that was used in the Debtors’ plan of reorganization. In support of their cases, the Debtors and the equity holders both hired experts to testify with respect to the valuation of Chemtura. The valuation methodologies employed by the experts consisted of a Discounted Cash Flow Method, a Comparable Companies Method, and a Precedent Comparable Transactions Method. It should be noted that the expert for the equity holders did not compute actual valuations based on the latter two methods, and instead used them only as a check on the reasonableness of its Discounted Cash Flow analysis. This methodology was looked upon very unfavorably by Judge Gerber in his decision given the facts and circumstances in this case.
There were many similarities in the application of the Discounted Cash Flow Method (“DCF”) by the two experts, including consistent projections and required rates of return. The one significant difference in this analysis related to the estimation of the terminal value of Chemtura. The debate over terminal value was driven by what level of terminal EBITDA was appropriate to consider when estimating the value of the Debtors. The expert for the equity holders applied its concluded terminal multiple to the EBITDA for the last year of the forecast period, while the expert for the Debtors applied the multiple to a mid-cycle, or normalized, EBITDA given the Debtors’ cyclicality.
Chemtura was operating in a cyclical industry. Further, Chemtura’s CFO admitted in sworn testimony that the projections were aggressive, as the long-range plan included projected performance that had never before been achieved by the Debtors. As such, applying a multiple to the height of Chemtura’s projections with no consideration given to the cyclicality of the business, or the potential for a downturn, was deemed unreasonable in this case.
Giving some insight into his thoughts on this methodology in general, Judge Gerber stated, “For the terminal value calculations, using the cash flows in the last projected year is not just common, but the more traditional approach (at least before considering the cyclicality of the company's business).” Judge Gerber also stated, “In this economic environment, relying on the very high terminal value in the last year of an admittedly aggressive string of growth projections is in my mind too aggressive. In a more stable economic environment, I'd likely consider use of the last year's cash flows for determining terminal value to be perfectly ordinary, if not also preferred. But I don't think that the present economic uncertainties permit an analysis that is so subject to assumptions that are so optimistic.”
It can be interpreted from the Bankruptcy Court’s decision that the methodology employed by the expert for the equity holders would normally be considered common practice. However, an expert cannot simply rely on standard methodologies if the company being valued is subject to special circumstances that impact value (e.g., operating in a cyclical industry or operating under overly aggressive projections).
The primary difference between the experts in the Comparable Companies analysis was the criteria used for choosing comparable public companies. The primary factors under dispute were location (i.e., foreign vs. domestic) and size. Further, the expert for the equity holders did not actually have a conclusion with respect to the Comparable Companies analysis. This was disappointing to Judge Gerber, as he stated, “I consider Comparable Companies analysis to be somewhat more meaningful here than either DCF or Comparable Transactions analysis, because it's less susceptible to uncertainties in projections (in the case of DCF) or extraneous factors such as control premiums, synergies, or bidding wars (in the case of Precedent Transactions).”
With respect to location, Judge Gerber held that it was appropriate to include foreign comparable public companies in the valuation of Chemtura for the following reasons: 1) they operate in the same markets; 2) they make similar products; 3) they are subject to similar tax and regulatory environments; 4) half of Chemtura’s revenue comes from outside the United States; and 5) Chemtura competes with these companies directly. The Court essentially concluded that while it is not necessarily true that foreign comparable companies should always be considered, if the subject company is operating and competing internationally, it may be appropriate to rely on the multiples of foreign companies.
With respect to choosing comparable public companies of similar size, Judge Gerber stated, “DuPont and PPG dwarf the Debtors in sales, EBITDA, enterprise value, and market cap. For instance, DuPont's revenues are nearly 18 times that of Chemtura's. As materially larger companies, they aren't as risky and trade at higher multiples… Their inclusion in the analysis inappropriately results in a higher value.” As many studies have shown, larger companies tend to trade at higher multiples, all else held constant. As such, it may not be appropriate to include significantly larger public companies in a valuation analysis without adjusting the implied multiple to account for size differences.
In the application of the Precedent Comparable Transactions method, one of the biggest areas of dispute was whether it was reasonable to use transactions that were consummated before September 15, 2008, the day Lehman Brothers filed bankruptcy. The other highly contentious topic was whether the multiple from a transaction that had not yet closed could be relied upon in the valuation.
Since the bankruptcy filing of Lehman Brothers in the fall of 2008, the stock market had been on a roller coaster and the transaction market had changed drastically. As such, a significant area of contention in the valuation of Chemtura came down to whether or not transactions pre-dating that point in time (which typically had higher multiples) were still relevant for a current valuation. Judge Gerber concluded, “[The expert for the Debtors] noted that the global economy fell into a tailspin after the Lehman bankruptcy, and that the financial system froze and global stock markets collapsed, causing the worst recession since the Great Depression. Credit necessary to finance acquisitions is far less available today. I accept [the Debtors’ expert’s] testimony that advanced economies are fundamentally different today, and that relying on multiples from a time period before the crash is inappropriate.” As such, any current valuation that includes precedent transactions that occurred prior to the financial collapse in the fall of 2008 should be viewed with a sense of skepticism.
In a definitive statement on the use of pending transactions in the Precedent Comparable Transactions method, Judge Gerber stated, “definitive documentation had been entered into that (unless conditions providing for rights of withdrawal were satisfied) obligated the parties to close, and that neither buyer nor seller could walk from the deal. The price of the deal already was fixed, by documentation binding on the parties. If the whole idea of a valuation is to determine what a willing buyer will pay and a willing seller will accept, and that already has been determined, it is not at all persuasive to contend that a deal with executed definitive documentation must be ignored simply because it has not yet closed. Indeed, if there is temporal proximity, as there is here, such a deal, even if not yet closed, may be the best comparable of all.”
Ultimately, the Bankruptcy Court stated that, “Precedent Transactions analysis has to be used with some care to normalize for extraneous factors that may be present in individual cases and increase the prices in those transactions-like control premiums, a willingness to pay more to obtain operational synergies, and hostile transactions.” As such, based on these factors, which typically exist in a transaction, the multiples implied by the Precedent Comparable Transactions method often represent the upper bound of a reasonable valuation conclusion.
In addition to the three valuation methodologies discussed previously, in order to further support the valuation conclusion for Chemtura, Judge Gerber also considered two pieces of market information that could be gleaned from the bankruptcy process.
During the negotiation process of this reorganization, one course of action that was undertaken by the equity holders was to market the Debtors for sale. The Debtors cooperated with this effort in order to find out if Chemtura could truly be sold at the value that the equity holders were contending was appropriate for the reorganization. However, when the equity holders marketed the Debtors at the price that they were using in their own plan of reorganization, there were no takers. In fact, no offers were made at all for Chemtura despite a relatively robust process. Further, none of the equity holders were willing to put in their own money at that price (despite the fact that several owners were hedge funds), or even a lower price, a fact that lead Judge Gerber to believe that the price being proposed by the equity holders was too high, and not indicative of a fair value.
The second piece of real world evidence that leads to the conclusion that the value purported by the equity holders was too high is the form that the creditors chose to take their distributions. The plan of reorganization allowed the creditors to choose between cash or stock. If the value of Chemtura being used in the Debtors’ plan were truly understated, one would expect all of the creditors to jump at the opportunity to take stock, and lock in an immediate return when the “true” value was realized. However, the overwhelming majority of the creditors chose cash, which implies that the value of Chemtura being used in the plan was not understated, at least in the eyes of the creditors when real money was on the line.
After Judge Gerber rendered his decision with respect to the valuation analyses prepared by each of the experts, he made special note of several significant credibility issues that the Bankruptcy Court had to contend with during the expert testimony. Three of the major credibility issues addressed were: 1) inconsistency between trial and deposition testimony; 2) failure to revise valuation conclusions in the face of changed economic circumstances; and 3) contingent fee arrangements.
The first two items of note appear to be relatively straightforward and obvious. It is always important for an expert to have consistent testimony at deposition and trial. In this case, however, despite hiring experts from well-known firms, this did not happen, and it hurt the cases for both sides. Further, as bankruptcy cases often drag out for months or even years, it is important for experts to consistently update their valuations as economic and industry factors change over time. If an expert testifies to a valuation that was performed six months prior (and the world has changed over those six months) without updating the analysis, the credibility of the expert will be diminished in the court’s view, as was the case in Chemtura.
The final issue of credibility that Judge Gerber addressed is a little more tricky. It is very common for financial advisors in a bankruptcy proceeding to have fees that are contingent on a successful outcome for their client. However, when that financial advisor then has to testify in court, the contingent fee arrangement can cause considerable credibility concerns. As Judge Gerber noted in this case, “In my experience, provisions like those in [the experts’] agreements are common… I approved each of them when authorizing the retentions of the three firms, and in my view there is nothing inherently wrong with them. They're unobjectionable as a means of incentivizing investment bankers to find buyers or investors, or to make deals, if they're regarded by stakeholders as necessary or desirable to achieve those ends. But such provisions can't be ignored when investment bankers testify… they materially and adversely affect witness credibility… I think it’s sufficient that we merely take contingent fees or incentive compensation into account as adversely affecting credibility, and ultimately take such opinions with a grain of salt.” Based on this sentiment from the Bankruptcy Court, it appears that while the incumbent financial advisor may seem to be the obvious choice to testify to valuation issues, it may be advisable to hire an independent valuation expert that does not have a contingent fee arrangement to testify to the critical valuation issues at the confirmation hearing.
The decision from Judge Gerber in the Chemtura bankruptcy confirmation hearing gives us a wealth of knowledge with regard to how the Bankruptcy Court views many issues related to valuation and the various methodologies. Further, the decision addressed the importance of considering real world tests to corroborate valuation conclusions. Finally, the Bankruptcy Court also made special note of the importance of hiring a credible and independent valuation expert, which in many cases, should not be the current financial advisor that will likely be viewed as having a strong bias given the contingent fee compensation arrangements.