Due Diligence.

Special Situations Due Diligence

Special situations investments refer to unique opportunities that arise due to certain circumstances such as mergers, acquisitions, or bankruptcy. The analysis is more detailed in private markets than in public markets due to the role of analysis in establishing a business plan for value creation over a long holding period. However, due to the short-term, cyclical, and event-driven nature of distressed situations, investors typically have less time to conduct due diligence and evaluate prospective investments. For instance, in the case of a company like Toys “R” Us filing for bankruptcy, investors would need to quickly assess the situation and make investment decisions.

Screening opportunities to prioritize specific investments is a crucial initial step in the process. Key criteria such as issuer ratings, company size based on market capitalization, observed market prices of distressed bonds, and leverage ratios, such as debt/EBITDA, can help narrow investor focus on fewer targets whose debt is currently priced lower than expected based on observed financial ratios. For example, if a large company like General Electric has a low issuer rating and high leverage ratio, it may be a potential investment opportunity.

Statistical Credit Analysis Models

Statistical credit analysis models to measure creditworthiness often use the structural credit models introduced earlier or reduced form models. Unlike structural models, such as the Merton Model, reduced form models are not based on capital structure assumptions. Reduced form models provide a probability of default over a specific time frame, typically using observable company-specific variables, such as financial ratios, and market-based measures. For instance, a company like Tesla with high financial ratios and market-based measures may have a low probability of default according to reduced form models.

Z-Score Model

The Z-score model, developed by Edward Altman, is a financial tool used to predict the probability of bankruptcy within a company. It combines five key financial ratios to assess a company’s financial health and stability:

• Liquidity Ratio: The liquidity ratio is represented by the equation \( \frac{\text{Working Capital}}{\text{Total Assets}} \), which measures the company’s ability to pay off its short-term liabilities with its short-term assets. A higher ratio indicates a more liquid (and potentially more financially stable) company.
• Profitability Ratio: This ratio is calculated as \( \frac{\text{Retained Earnings}}{\text{Total Assets}} \) to gauge a company’s profitability relative to its size. It reflects how effectively a company has been able to generate profits over time. More retained earnings typically suggest a company with a solid foundation and less risk of bankruptcy.
• Asset Efficiency Ratio: Calculated by \( \frac{\text{EBIT}}{\text{Total Assets}} \), this ratio assesses how efficiently a company utilizes its assets to generate earnings. Higher efficiency indicates a company is better at converting its assets into profits, which is a positive sign for financial health.
• Market to Book Ratio: This ratio, given by \( \frac{\text{Market Value of Equity}}{\text{Book Value of Equity}} \), compares the market’s valuation of a company to its book value as recorded on the balance sheet. A higher market-to-book ratio may indicate the market’s confidence in the company’s future performance.
• Asset Turnover Ratio: Represented by \( \frac{\text{Sales}}{\text{Total Assets}} \), this ratio measures how effectively a company uses its assets to generate sales. It’s an indicator of operational efficiency, where higher values suggest better performance in utilizing assets to increase revenue.

By analyzing these ratios collectively, the Z-score model offers a comprehensive view of a company’s financial stability, making it a valuable tool for investors and analysts to predict bankruptcy risk. These factors are weighted by coefficients to form a composite, or Z-score, used to classify firms into those expected to remain solvent versus bankrupt firms. For example, a company with a high Z-score like Apple would be classified as likely to remain solvent.

Structural Credit Models

The structural models are also applied to estimate an issuer’s probability of default to be considered along with the expected loss given default when evaluating the price of a distressed issuer’s securities. Two of the typically used models are:

Moody’s Analytics’ Expected Default Frequency (EDF): This model calculates the likelihood of a firm defaulting within a specific timeframe, using market data and the firm’s financial health indicators.

Bloomberg’s Default Risk (DRSK) models: DRSK assesses default risk by analyzing market data, financial performance, and industry trends to estimate a company’s probability of default over a chosen period.

For instance, a company like Ford may have a high probability of default according to these models.

Investment Strategies in Distressed Issuers

Investing in private markets and distressed issuers presents unique challenges due to the lack of transparent information and the potential for rapid changes in the issuer’s financial condition. These challenges necessitate a robust due diligence process.

Types of Investors and Their Strategies

Short-Term, Trading-Based Investors: Such as credit hedge funds, these investors leverage public information to identify and act upon temporary mispricing in the market. An example includes a hedge fund exploiting the temporary mispricing of a technology company’s stock triggered by a sudden market downturn.

Long-Term Investors: These investors are typically involved in the restructuring process of distressed companies, either through controlling or non-controlling stakes. Their investment decisions are based on a comprehensive due diligence process that assesses the potential for influence over the outcome of a reorganization and the ability to create value as the issuer recovers from bankruptcy. An investment strategy might evolve from acquiring a minority position to a controlling stake based on ongoing due diligence findings.

Challenges in Accessing Information for Due Diligence

The lack of readily available public information and the reluctance or inability of company management to share crucial data with potential investors make the due diligence process especially critical. Access to important non-public information, such as customer lists, sales projections, or commercial contracts, is often restricted to a bank or lending group under a confidentiality agreement, limiting the trading and decision-making abilities of other prospective investors.

Financial Due Diligence Considerations

Financial due diligence for private investments is comprehensive, involving the analysis of financial statements, cash flow projections, industry and competitive analysis, and a worst-case scenario planning for liquidation. For companies in bankruptcy, it includes a detailed review of bankruptcy filings, monthly operating reports, and any other documentation that can shed light on the firm’s financial status and creditor hierarchy.

Legal Due Diligence in Distressed Situations

Legal due diligence extends beyond evaluating the company’s legal and organizational structure and outstanding litigation. It involves a thorough review of loan agreements and indentures across different legal entities to identify potential consolidation, structural, or financial issues that could affect creditor claims during the bankruptcy process. Special attention is given to identifying any voidable preferences that might be reversed in bankruptcy court.

Valuation Techniques for Special Situations Investing

Investors employ a variety of valuation techniques akin to those used for assessing public and private companies as going concerns. These include income-based approaches, which focus on future earnings potential; relative approaches, which compare the distressed company to its peers; and asset-based approaches, which value the company based on its assets.

Special Situations Valuation Approaches

Income-based Approaches: Income-based approaches are predicated on discounted projected cash flows and a terminal value using assumed constant growth or a terminal market multiple. This approach zeroes in on the potential income that a company can generate in the future. For instance, if a tech startup projects a steady increase in its revenue over the next five years, an income-based approach would take these projections into account to determine the company’s value.

Relative Approaches: Relative approaches, also known as the method of comparables, are predicated on price-based or enterprise value-based multiples of firms with similar features. This approach juxtaposes the company to similar companies in the market to ascertain its value. For example, a relative approach might compare a new e-commerce company to established companies like Amazon or eBay to determine its value.

Asset-based Approaches: Asset-based approaches aim to estimate the value of underlying assets less liabilities. This approach focuses on the company’s tangible and intangible assets and subtracts its liabilities to determine its value. For instance, a manufacturing company’s value might be determined by assessing the value of its factories, equipment, and inventory (tangible assets), as well as its brand and patents (intangible assets).

One of the main challenges in valuing special situations is how to incorporate the likelihood, timing, and financial impact of specific events that give rise to investment opportunities. Firms may face future alternatives that may be considered real options under a distressed scenario that can alter firm value. Real options grant a firm the right but not the obligation to decide or take an action in the future. A company will choose to pursue (or exercise) a real option only if it enhances shareholder value. These options might include the sale of individual assets or an entire division of a firm. A related approach involves a sum-of-the-parts valuation , which considers the value of a firm’s individual business segments if they were to be sold separately.

Challenges in Applying the DCF Model to Distressed Companies

Valuing a distressed company using the standard Discounted Cash Flow (DCF) approach presents unique challenges that impact the valuation’s accuracy and reliability. These challenges are categorized into three main areas:

1. Numerator Issues: Forecasting Cash Flows

   Adjustments Required: Financial distress significantly alters a company’s operational norms, necessitating adjustments to balance sheet and income statement items to reflect a more accurate picture of normalized earnings.

   Estimation Difficulty: The timing and magnitude of event-driven changes to revenue and cash flow due to distress are challenging to predict accurately, complicating cash flow forecasts.

2. Denominator Issues: Discount Rates

   Illiquidity and Complexity: The relative illiquidity of the company’s debt and its complex capital structure pose significant challenges in determining the appropriate discount rates for valuing future cash flows.

   Distressed Debt Yields: Distressed debt often trades at a significant discount to par, meaning its yields do not accurately reflect the expected rate of return, further complicating the selection of an appropriate discount rate.

3. Terminal Value Issues

   Going Concern Assumption: The DCF model’s reliance on the assumption that a firm will remain a going concern is particularly problematic in valuing distressed companies, where this assumption may not hold.

   Valuation Distortions: Assuming a future terminal growth rate or applying market multiples based on non-distressed valuations can lead to significant distortions when valuing a company that may be restructured or liquidated in the near term.

Relative value Comparisons

Another method of valuation is relative value comparisons using market multiples. However, these can also be misleading in cases of financial distress. These comparisons are typically calculated using ratios from non-distressed industry peers, which may not accurately reflect the situation of a distressed firm. For example, comparing a distressed airline company like Air India with a non-distressed peer like Indigo Airlines may not provide an accurate valuation. However, a relative value approach can be applied if the firm is considered a going concern, meaning it has avoided dissolution.

Asset-Based Valuation Approach

Asset-based valuation approaches depend on whether the market value is estimated as part of an ongoing business or if the assets are sold individually and separate from the business. If a firm cannot restructure its activities and obligations to meet creditor obligations as a going concern, selling its assets individually to settle claims may be the best course of action. For instance, consider a company like Toys “R” Us that had to sell its assets to pay off its debts. The liquidation value of a firm’s assets often represents a lower bound for valuation purposes.

Liquidation

Liquidation usually occurs when a firm is uncompetitive, its assets are inadequate or outdated, or the company’s management is ineffective. Valuing a firm’s outstanding securities under liquidation involves comparing the value of firm assets \(V_t\) to debt \(D\) based on the priority of claims. If there is a shortfall \(V_t – D\) between asset liquidation values and debt, senior secured lenders will likely be repaid in full from liquidation proceeds, while subordinated lenders may face a settlement value below the face value of debt.

An alternative to liquidation is a going concern scenario, which values the firm under the assumption that it survives and continues to operate. This approach avoids the valuation pitfalls associated with financial distress and allows for the use of valuation metrics such as market multiples for healthy industry peers. The default probability used in this scenario analysis may be derived from a structural or reduced form model, and the scenarios may incorporate varying liquidation or restructuring assumptions. By isolating financial distress based on specific scenarios and including a going concern recovery case, financial analysts can tailor a valuation to changing market conditions.

Practice Questions

Question 1: Statistical credit analysis models are used to measure creditworthiness. These models can be either structural or reduced form models. If a model provides a probability of default over a specific time frame, typically using observable company-specific variables, such as financial ratios, and market-based measures, which type of model is it likely to be?

1. Structural credit model
2. Reduced form model
3. Neither structural nor reduced form model

Answer: Choice B is correct.

A model that provides a probability of default over a specific time frame, typically using observable company-specific variables, such as financial ratios, and market-based measures, is likely to be a Reduced Form Model. Reduced form models, also known as intensity-based models, are a type of credit risk model that estimates the probability of default without making assumptions about the company’s financial structure. These models use observable market data and company-specific variables to estimate the likelihood of default. They are often used in the credit derivatives market and for pricing corporate bonds. Reduced form models are particularly useful for assessing the credit risk of companies with complex capital structures or where detailed financial information is not available.

Choice A is incorrect. Structural credit models, also known as Merton models, are based on the company’s financial structure and assume that default occurs when the value of a company’s assets falls below the value of its debt. While these models do use company-specific variables, they do not typically use market-based measures and do not provide a probability of default over a specific time frame.

Choice C is incorrect. The description provided in the question clearly aligns with the characteristics of a reduced form model. Therefore, it is not correct to say that it is neither a structural nor a reduced form model.

Question 2: An investor is considering investing in a distressed company. As part of the due diligence process, the investor is trying to understand the company’s financial conditions and potential for restructuring. The investor is also aware of the need to evaluate the company’s legal commitments and outstanding litigation. In this context, which of the following would be the most appropriate approach for the investor to take in order to make an informed investment decision?

1. Focus solely on the company’s financial statement analysis, cash flow projections, and industry and competitive analysis.
2. Limit the due diligence process to public information and focus more on the relative liquidity of instruments under consideration.
3. Conduct a thorough financial and legal due diligence, including a worst-case liquidation scenario, review of bankruptcy court filings, and understanding of firm structure and loan agreements.

Answer: Choice C is correct.

When considering investing in a distressed company, it is crucial to conduct a thorough financial and legal due diligence. This includes a worst-case liquidation scenario, review of bankruptcy court filings, and understanding of firm structure and loan agreements. This approach is the most comprehensive and provides the investor with a complete picture of the company’s financial health, legal obligations, and potential for restructuring. It also allows the investor to assess the risks associated with the investment and to make an informed decision. The worst-case liquidation scenario helps the investor understand the potential losses in the event of a company’s liquidation. Reviewing bankruptcy court filings provides insights into the company’s legal commitments and outstanding litigation. Understanding the firm structure and loan agreements helps the investor assess the company’s debt obligations and the potential for restructuring.

Choice A is incorrect. While financial statement analysis, cash flow projections, and industry and competitive analysis are important components of due diligence, they are not sufficient when considering investing in a distressed company. They do not provide a complete picture of the company’s financial health and do not take into account the company’s legal obligations and potential for restructuring.

Choice B is incorrect. Limiting the due diligence process to public information and focusing more on the relative liquidity of instruments under consideration is not an appropriate approach when considering investing in a distressed company. This approach does not provide a complete picture of the company’s financial health and does not take into account the company’s legal obligations and potential for restructuring. It also does not allow the investor to assess the risks associated with the investment.

Glossary:

• Going Concern: An accounting concept that assumes a company will continue its operations in the foreseeable future.
• Income-based Approaches: Valuation methods that focus on a company’s potential future income.
• Relative Approaches: Valuation methods that compare a company to similar companies in the market.
• Asset-based Approaches: Valuation methods that focus on a company’s tangible and intangible assets.
• Real Options: Future alternatives that a company can choose to pursue if they enhance shareholder value.
• Sum-of-the-parts Valuation: A valuation method that considers the value of a company’s individual business segments.
• Normalized Earnings: Adjustments made to a company’s financial statements to show what earnings would have been under normal conditions.
• Terminal Value: The estimated value of a business beyond the explicit forecast period.
• Special situations investments: Unique investment opportunities that arise due to certain circumstances such as mergers, acquisitions, or bankruptcy.
• Issuer ratings: Ratings given to issuers of debt by credit rating agencies, indicating their creditworthiness.
• Market capitalization: The total market value of a company’s outstanding shares of stock.
• Due diligence: An investigation or audit of a potential investment or product to confirm all facts, such as reviewing all financial records, plus anything else deemed material.
• Restructuring: A corporate action taken by a company to significantly modify the financial and operational aspects of the company, usually when it is in financial duress.
• Liquidation: The process of bringing a business to an end and distributing its assets to claimants.
• Voidable preference: A transfer of property or payment made by a debtor to a creditor within a certain period of time before a declaration of bankruptcy that can be set aside under bankruptcy law.
• Distressed bonds: Bonds issued by companies that are near to or in default.
• Leverage ratios: Financial metrics that measure the amount of debt a company is using to finance its assets.
• Structural credit models: Models that estimate the probability of default of a company based on its capital structure.
• Reduced form models: Models that estimate the probability of default of a company based on observable company-specific variables and market-based measures.
• Z-score: A statistical measurement that describes a company’s financial health.
• Expected Default Frequency (EDF): A measure of the probability that a firm will default on its financial obligations.
• Default Risk (DRSK): The risk that a company will be unable to pay its financial obligations.
• Discounting future cash flows: A method used to estimate the value of an investment based on its future cash flows.
• Terminal growth rate: The constant rate at which a firm’s free cash flows are assumed to grow indefinitely.
• Market multiple: A ratio used to value a company by comparing its stock price to a fundamental financial metric.
• Relative value: A method of determining a security’s value by comparing its price to that of other securities.
• Structural model: A type of credit risk model that uses the firm’s equity value as a starting point to understand the credit risk.

Private Markets Pathway Volume 2: Learning Module 5: Private Special Situations; LOS 5(d): Discuss the due diligence and valuation processes used to evaluate special investment situations.