With the return of dividend recapitalizations and leveraged buyouts and a continued focus on distressed transactions, solvency opinions are, once again, on the rise. However, the Great Recession left a number of failed solvency opinions in its wake. Some of the most high-profile solvency opinions issued during the last peak of the M&A markets have not fared well. In 2008, the Delaware Chancery Court was critical of a 2007 solvency opinion issued in the $10.6 billion failed Hexion/Huntsman deal.2 In 2009, a U.S. Bankruptcy court in Florida took exception with the solvency opinion issued just six months prior to the bankruptcy of homebuilder, TOUSA.3 In 2010, a special examiner appointed by the U.S. Bankruptcy Court for Delaware, devoted nearly 100 pages of his report to an unflattering assessment of a solvency opinion issued to support the $8.2 billion leveraged buy-out of the Tribune Company.4 One year later the Tribune Company filed for bankruptcy.
What went wrong? Why did these solvency opinions fail? Certainly, some of the blame is attributable to the widespread excesses of the credit market, the same excess that resulted in the Great Recession. However, a closer review and comparison of these three solvency opinions provides a roadmap for significantly improving the efficacy of future solvency opinions. A post-mortem of these opinions highlights four factors that can doom – or redeem – solvency opinions as the M&A landscape begins to improve.
Critical Assessment of Management Projections
The financial advisors for all three solvency opinions were criticized for failing to critically assess management’s financial projections. In Hexion, the judge remarked that the solvency opinion “was based on skewed numbers” provided by the private equity firm that controlled the acquiring company. In this instance, the court suggested that the projections were unduly pessimistic, resulting in a contestable conclusion of insolvency. In TOUSA, the judge criticized the financial advisor for “rely[ing] heavily (if not exclusively) on the assumptions and projections provided by TOUSA.” Reflecting the more typical criticism, this court found management’s projections to be unrealistically optimistic, resulting in a questionable conclusion of solvency. In Tribune, the examiner found that although the financial advisor appears to have questioned the optimism of management’s projections, it nonetheless “unreasonably ignored its own internal critique”. Here, too, the criticized result was a questionable conclusion of solvency.
Financial projections are the starting point for most solvency opinions. In the ordinary course, company management prepares financial projections for the business in question and hands them off to the financial advisor to begin the solvency analysis. However, prior to beginning the analysis, the financial advisor might pause and ask two key questions: Were these projections prepared by the same people, and using the same process, as the
projections by which the company normally manages its business? How do these projections compare to other recently prepared projections? By asking these questions, a financial advisor can better avoid transaction or litigation driven projections that may bias the solvency opinion.
According to the judge’s written opinion, TOUSA’s executive management team normally sought input from regional executive vice presidents and regional chief financial officers when preparing financial projections. However, for the projections provided to the financial advisor, the company “did not seek input from its field operations on its long term projections, and its regional managers did not review the projections.” When questioned in deposition, various regional presidents stated that they were “unaware” that management was preparing long-term projections. Perhaps most damaging, when shown the projections provided to the financial advisor, the president of TOUSA’s largest division testified that “he would not have made such a forecast at the division level.”
The situation was more complicated for the Hexion solvency opinion. The projections that formed the basis of the solvency opinion were intended to reflect the combined businesses of Hexion and Huntsman.5 From the judge’s written opinion we know that the management of Hexion prepared the projections given to the financial advisors. We are not told whether these projections were prepared in the same manner in which Hexion (as a standalone company) normally prepared its projections. However, the opinion does make clear that the financial advisors did not speak with Huntsman’s management regarding the projections. Therefore, one can make an assumption. To the extent that the projections were intended to include the results of operations for Huntsman, that portion of the projections could not have resulted from the same process by which Huntsman had historically created financial projections. The judge appears to note this discrepancy when he describes the process by which Huntsman (in connection with the litigation) prepared alternative projections. He writes: “Huntsman began to update its own projections by having each of its divisions prepare EBITDA estimates.” The judge’s opinion also recounts the testimony of Huntsman division leaders in which they discuss specific operational support for Huntsman’s alternative projections. Although the judge was not wholly persuaded by Huntsman’s litigation-influenced projections, Huntsman’s projections, which appear to hew closer to the historical forecasting process, compared favorably to those prepared by Hexion.
In TOUSA and Hexion, the financial advisors relied on projections that did not involve the same people or reflect the same process as projections by which the company normally managed its business. As a result the advisors relied on projections that were (or were perceived to be) inaccurate, if not biased. In the eyes of the judge or special examiner, this doomed the solvency opinion.
There is a second question that financial advisors might ask upon receiving projections from management: How do these projections compare to other projections that existed prior to the contemplated transaction? At a minimum, there are three sets of projections to which comparison should be made, those presented to: the company’s board of directors, to existing lenders and/or investors (including Wall Street research analysts), and to the company’s outside auditors. Perhaps amid pressure or time constraints to complete the transaction, each of these three solvency opinions were undermined by either a failure to make such a comparison or a failure to explain why the projections were different – and more favorable to the solvency conclusion reached by the financial advisor.
In Tribune, the special examiner compared two sets of financial projections. Both were prepared by company management, the first in February 2007 and the second in October 2007. In issuing its solvency opinion, the financial advisor relied upon the more optimistic October 2007 financial projections.6 However, in comparing the two sets of projections, the examiner found that the company’s failure to meet the more modest February projections, coupled with a significant deterioration in the business, should have resulted “in a downward adjustment of the out-year assumptions” for the October 2007 projections. Instead, in each of the last five years of the 10-year projection period, the October projections were higher than the February projections. The examiner was harshly critical of the financial advisor for seemingly failing to make the same comparison before relying on the October projections.
In TOUSA, a similar situation arose (although, it is difficult to determine the extent to which the financial advisor or company management was more at fault). Only eight days after the financial advisor issued its solvency opinion, TOUSA’s CEO presented different financial projections to the chairman of the Board of Directors. As noted in the judge’s opinion, the “best case” scenario presented to the chairman projected worse financial results for the company than the “base case (i.e. likeliest)” projections upon which the financial advisors had relied when issuing the solvency opinion. Further, a draft of the presentation to the chairman (containing the lower projections) was prepared at least a week before the solvency opinion was issued.
The Hexion solvency opinion was also undermined by two different financial projections. In February 2008, Apollo provided financial projections to two financial advisory firms for the purposes of valuing the combined Hexion/Huntsman entity. This was not in connection with the solvency opinion. Based on the February projections, the value of the combined entity was estimated to be $15.8 billion. Four months later, Apollo provided different financial projections to the financial advisor issuing the solvency opinion. Using the June projections, the value of the combined entity was estimated at $11.4 billion. There is insufficient public information to determine whether the changes to the financial projections were justified or whether the changes to the projections were the primary cause of the lower valuation. However, for failure to reconcile the $4.4 billion difference in value – over only a four month period – the latter projections were viewed skeptically by the court.
By comparing and reconciling different sets of projections prepared in reasonable proximity to the date of the opinion, the financial advisor can better understand the reliability of a given set of projections and can avoid projections that may bias the solvency analysis.
Stress testing is a critical component of solvency analysis. An affirmative solvency opinion requires that the company will remain solvent even through a reasonably expected downturn. Once the financial advisor believes that management’s projections reasonably present the expected performance of the company (a so-called “base case”), the next step is to determine an appropriate downside scenario that facilitates a useful stress test of the base case. A “downside scenario” is typically captured by an alternative financial projection that attempts to quantify the impact of various adverse developments in the operations (or financing) of the company. For example, the downside scenario may include one or more of the following assumptions: the company loses a significant contract; new competition reduces unit sales; capital expenditures run significantly above budget; wholesale costs increase, reducing gross margins; or adverse litigation that results in a significant financial payout. TOUSA and Tribune highlight the limitations of relying solely on company management to develop the downside scenario.
In TOUSA, the financial advisor concluded that the company would be solvent under a “downside case” for the financial projections. However, for the downside case, the advisor relied upon a set of management projections that had been used to negotiate loan covenants with TOUSA’s lenders. Yet such a model runs the risk of presupposing the answer. If the lender is already prepared to provide the loan, it is highly unlikely that the model upon which the loan is predicated will show a breach of the financial covenants or any other indicia of insolvency. Therefore, it is troubling to use that very model as an independent basis to assess the company’s solvency.
For Tribune, the case is more curious. The examiner found that the financial advisor had, indeed, developed several downside scenarios. These scenarios reportedly incorporated third-party market data and information gleamed from meetings with Tribune management. The examiner described much of the analysis as “astute.” Nonetheless, the financial advisor did not incorporate any of these downside scenarios in the analysis supporting the solvency opinion. Instead, the financial advisor relied exclusively on the management-prepared “Tribune Downside case forecasts” to perform a stress test of the base case forecast. Under management’s more optimistic downside case, the company was shown to remain solvent.
The purpose of stress testing the company’s expected financial performance is to understand the implications for the company’s solvency should unfavorable conditions develop. By relying solely on management to develop a downside scenario, the financial advisor assumes that management will objectively create a scenario that could show the failure of the business and by inference, the failure of management. While exceptions certainly exist, it seems dangerous for financial advisors to solely rely on such an assumption.
A final word on management projections raises tough questions for financial advisors. In TOUSA, the judge took issue with the fact that the financial advisor’s engagement letter stated that the advisor “would ‘not take any action to verify the accuracy or completeness’ of the information on which its opinion would be based.” Yet, in point of fact, this or similar language is standard industry practice. The following clause was included in the opinion letter issued by the financial advisor in Hexion:
[We] relied upon the accuracy, completeness, and fair presentation of all information, data, advice, opinions
and representations obtained from public sources or provided to us from private sources, including Management, and did not attempt to independently verify such information [emphasis added].
This language affords legal projection to financial advisors in the face of real risk. It also addresses the company-specific information gap between financial advisors and company management. Management knows information about the company that the financial advisor does not know. However, if a legitimate concern is that an inappropriate reliance on such language turns financial advisors into nothing more than adding machines (using management data), perhaps we have arrived at an untenable outcome.
Integrating Solvency Analysis with Industry Knowledge
In Hexion, TOUSA, and Tribune, the solvency analysis appears to have been compromised by insufficient industry expertise. Solvency analysis is a specific area of expertise that combines valuation, credit analysis, and knowledge of relevant legal and statutory solvency frameworks. However, like most areas of financial analysis, comprehensive solvency analysis must incorporate an understanding of the industry in which the company operates and any specialized assets or liabilities pertaining to the company or the industry.
In both Hexion and Tribune, the financial advisors were criticized for their selections of reportedly comparable companies or transactions.7 In Hexion, the criticism was levied by an opposing expert. The financial advisor who performed the solvency analysis was criticized for equating commodity chemical companies with the combined Hexion/Huntsman entity, a specialty chemical business. This conflation matters because specialty chemical companies tend to command higher valuations than commodity chemical companies. The opposing expert also noted that the transaction identified by Hexion as most comparable to the combined Hexion/Huntsman business was a recent acquisition of a specialty chemical company. The financial advisor did not include this transaction in the solvency analysis.
In Tribune, the examiner appeared to question the financial advisor’s knowledge of the media industry. He noted that “several of the cohort firms identified and used by [the financial advisor] for the purposes of its trading multiples analysis appear insufficiently comparable to the Tribune Company to allow for meaningful valuation conclusions to be drawn”. In one example, he cited a company that generated over 42% of its revenue from network broadcasting. By contrast, Tribune generated 75% of its revenue from publishing. As a second example he dismissed as “demonstrably not comparable [to Tribune]” a company that derived “substantial revenue” from non-media operations. A second shortcoming of the Tribune solvency opinion also appears tied to lack of industry familiarity. The examiner noted that the financial projections used in the solvency analysis were incorrectly inflated by, effectively, assuming that each of the last five years of the forecast were presidential election years. Media company revenues are significantly higher in election years due to increased spending on political ads. The model reflected higher revenue for a year that was, in fact, an election year. However, this high revenue assumption was continued for five years beyond the actual election year.
In TOUSA, a lack of industry expertise led to the use of an incorrect valuation metric. This undermined the solvency opinion. EBITDA multiples are commonly used to value a company.8 For example, a company may be valued at six times EBITDA. However, for certain industries, EBITDA (or other cash flow measures) do not capture the true economic value of the company. Real estate is one such industry. The value of a homebuilder such as TOUSA, is more accurately represented by the value of the land and properties owned by the company. That is, the value of the company is best represented by the sum of the values of the assets owned by the company. In TOUSA, the financial advisor was criticized by an opposing expert for using an EBITDA multiple to value the company. The judge concurred with this criticism and accepted, in the alternative, the opposing expert’s more appropriate valuation metric.
Moving Solvency Analysis Beyond Valuation
Historically, solvency analysis emphasized a comparison of a company’s assets and liabilities. If the value of a company’s assets exceeded the value of a company’s liabilities, the company was considered solvent.9 In fact, this is only one of the three tests of solvency embodied in the U.S. Bankruptcy Code. The other two tests (paraphrased) are whether the company can pay its debts and whether the company has, or can obtain, adequate capital to operate its business. These second two tests extend solvency analysis beyond traditional valuation analysis. In Hexion, TOUSA, and Tribune, the solvency opinions were undermined by an over-reliance on traditional valuation analysis and insufficiently rigorous credit analysis. In the last decade the sophistication of the fixed income capital markets has increased tremendously. If solvency opinions are to remain relevant, they must incorporate credit analysis that reflects today’s sophisticated fixed income markets.
In Tribune, a critical component of the credit analysis was the company’s anticipated ability to refinance its debt. In the first six years following the leverage buyout transaction, Tribune’s scheduled annual debt repayments averaged $172 million. However, in years seven and eight (following the LBO), Tribune was scheduled to repay debt of $6.3 billion and $1.7 billion, respectively. These amounts “vastly exceeded” the company’s projected available cash. Therefore, an affirmative solvency opinion for the Tribune leveraged buyout critically depended on the company’s ability to refinance debt at a future date. However, the financial advisor appears to have depended solely and entirely on information from the company and the lead investment banking advisor to support the refinancing assumption. In the examiner’s report there is no discussion of any independent refinancing analysis performed by the financial advisor who provided the solvency opinion.
When asked by the examiner how the financial advisor came to support the refinancing assumption, one of the senior team members responded that they looked at “two things.” The first was a review of management’s financial projections showing projected debt levels and loan covenant calculations. The second item was a representation letter from management. Glaringly absent from the financial advisor’s response is an analysis or, even review, of any data from the leveraged loan market. The only market data that the financial advisor appears to have reviewed were “some [leveraged] loan and [high yield] issuance precedents for TV/Newspaper companies going back to mid-2006.” This data was provided by the lead investment banker for the LBO transaction. There is no discussion of what, if any, analysis the financial advisor performed of this data. Although a copy of the data was not included in the examiner’s report, one fact is immediately noted. This data would have likely reflected the peak of leverage loan and high-yield bond activity in mid-2006. Further, a trend analysis of the leveraged loan and high-yield markets from mid-2006 to December 2007 (the date of the solvency opinion) should have easily revealed tightening credit markets. At a minimum, the trend analysis should have caused the financial advisor to more skeptically question the refinancing assumption.
In TOUSA, there were several credit markets indications that called the solvency of the company into question. It is unclear to what extent the financial advisor took these indications into consideration. The solvency opinion (or, at least, a substantially complete draft thereof) was issued at the end of June 2007. However, in March 2007, Moody’s Investors Service issued a negative outlook report on the homebuilding industry in which it specifically noted that TOUSA’s credit rating had been downgraded on two recent occasions. One month later, TOUSA’s bonds were trading at 30% to 40% of face value. In July, TOUSA bonds were downgraded, again, by the major credit rating agencies to CCC+. The July downgrade was precipitated by the company’s announcement that it would issue new debt (the very debt for which the solvency opinion was sought). In turn, this further increased the discount at which the company’s bonds were trading. Even as TOUSA was attempting to raise the new debt, the company was forced to make the terms of the debt more attractive after 50% of the lenders in the syndicate refused to lend. It also appears as though the financial advisor may have been incorrectly persuaded by the seeming willingness of the final lending group. The judge’s opinion notes that included in the new syndicate of lenders were lenders whose previous debt was refinanced. As a result, these lenders were able to “leverage themselves from an unsecured loan [to a TOUSA subsidiary] into secured loans to TOUSA and [its subsidiaries].” If these factors were taken into account in the solvency analysis, there is no discussion of such in the judge’s opinion.
Sophisticated credit analysis is a critical component of solvency analysis. The analysis underlying a solvency opinion should explicitly take into account relevant fixed income capital market data such as: changes in the company’s credit ratings, spreads on the company debt and credit default swaps, posture of existing or anticipated lenders, trends in issuance volume and industry leverage ratios.
Understanding the Motivation of All Players
As financial advisors gather and assess information from all of the entities in a financial transaction (e.g. company, lenders, other financial advisors, etc), it is important to consider the subtle – and not so subtle – biases that may impact the behavior of, and the information provided by, participants to the transaction.
From a reading of the court opinions and examiner’s report, it is not possible to ultimately conclude on the motivation of each of the participants involved in each transaction. However, it is instructive to review the judges’ and examiner’s opinions regarding such motivation. This can help financial advisors avoid the problems of perception that might arise if the solvency opinion comes under future scrutiny.
In TOUSA, the judge questioned whether the financial advisor should have relied on the willingness of the lead bank to arrange new financing as an indication of solvency. The judge was skeptical of the role that a large fee played in motivating the lead arranger. The judge also questioned whether the financial advisor should have been more skeptical of management’s acceptance of the transaction as the CEO stood to earn an incentive bonus for completing the transaction. In Tribune, the examiner’s report leaves open the question of whether the lead investment bank was motivated to not contest the refinancing assumption due to the fee that the bank would receive upon closing the transaction. In Hexion, the financial sponsor’s clearly identified litigation strategy, and the financial advisor’s knowledge of the same, doomed that solvency opinion.
When the lines of communication between the advisors and transaction participants are fettered, it only heightens skepticism about conflicts of interest. In Hexion, the financial advisor was “prevented from” speaking directly with the management team of the company being acquired. In Tribune, the financial advisor did not speak directly with the lead investment banking advisor or with the consortium of banks providing financing. However, the financial advisor relied upon information from these banks, especially the investment bank.
Lastly, financial advisors will continue to come under scrutiny by the courts for perceived conflicts of interest. In TOUSA, the financial advisor’s fee for providing a solvency opinion was effectively contingent upon issuing an affirmative opinion. The judge was highly critical of this non-standard payment arrangement. In Hexion, the judge questioned the objectivity of the financial advisor as the advisor knew that the acquirer intended to pursue litigation.
As we emerge from (hopefully) the worst of the financial crisis, greater attention is being paid to credit risk. Solvency opinions can be one tool to help companies and lenders manage credit risk. However, this requires that solvency opinions, and the analysis on which they are predicated, consistently demonstrate the rigor and objectivity that make them meaningful to capital market participants. Critically assessing management projections; integrating industry expertise; incorporating more sophisticated credit analysis; and considering the bias of participants in the transactions are four factors that can strengthen solvency analysis.
1 The information referenced in this article is based solely on publicly-available information. The author of this article was not personally involved in any of the transactions or litigation referenced in this article. Although this author previously held the position of Director at Duff & Phelps (the solvency opinion provider in the Hexion/Huntsman) matter, she was no longer affiliated with the firm upon the firm’s retention in that matter.
2 The case is Hexion Specialty Chemicals et al., v. Huntsman Corp., C.A. 3841-VCL, Court of Chancery of the State of Delaware.
3 The case is In re: TOUSA, Inc. et al.,: Official Committee of Unsecured Creditors of TOUSA, Inc. et al., v. Citicorp North America, Inc. et al., Case 08-01435-JKO, U.S. Bankruptcy Court S.D. FL (Fort Lauderdale).
4 The case is In re: Tribune Company, et al., U.S. Bankruptcy Court for the District of DE, Case 08-13141 (KJC), Report of Kenneth N. Klee as Examiner.
5 It was Apollo’s/Hexion’s position that the combined business, following the merger, would have been insolvent.
6 The financial advisor issued two solvency opinions in connection with the leveraged recapitalization of the Tribune Company. This article primarily references the second opinion.
7 Comparable companies or transactions are companies that significantly resemble the company being analyzed or transactions in which such companies are sold. The comparable companies and transactions are used to derive valuation multiples.
8 EBITDA = earnings before interest, taxes, depreciation and amortization.
9 Even today, one can find reference to this comparison as the “solvency test”.
