CIGA Restructuring Plan - A Valuer's Perspective FRP

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CIGA Restructuring Plan: A valuer’s perspective 10 plans in

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CIGA Restructuring Plan: A valuer’s perspective 10 plans in After 10 sanctioned Restructuring Plans (and one declined) it is evident that valuation is key to supporting the court’s decision- making process and a focal point for potential challenge. Valuation under the relevant alternative is the key to comparing Plan outcomes to those under the most likely counterfactual, and to demonstrating the fairness of a cross-class cram down where relevant. With the onus on proposing companies to provide the necessary evidence in support of a Plan, understanding and applying valuation best practice is critical in assessing the relevant alternative and proving the hypothesis that no party is worse off. Soundings from the first 10 Plans provide a helpful insight into what the process requires from a valuation perspective, and how expectations of the court are developing and building on the experience of valuation analysis in Schemes of Arrangement.

With the onus on proposing companies to provide the necessary evidence in support of a Plan, understanding and applying valuation best practice is critical in assessing the relevant alternative and proving the hypothesis that no party is worse off. Jim Davies Corporate Finance

Jim Davies Partner Corporate Finance - Valuation +44 (0)20 3005 4000 +44 (0)7841 829 826 jim.davies@frpadvisory.com

Phil Reynolds Partner Restructuring Advisory

+44 (0)20 3005 4270 +44 (0)7970 061 066 phil.reynolds@frpadvisory.com

Chad Griffin Partner Restructuring Advisory

+44 (0)330 055 5470 +44 (0)7789 920 997 chad.griffin@frpadvisory.com

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CIGA Restructuring Plan: A valuer’s perspective 10 plans in

Introduction

Valuation

CIGA Restructuring Plans as of August 2022

In June 2020 the Corporate Insolvency and Governance Act introduced a range of permanent measures aimed to relieve the burden on businesses both during and after the Covid-19 pandemic - amongst these measures was the Restructuring Plan (the “Plan”). The Restructuring Plan established a new tool for UK restructuring practitioners, drawing much of its substance from the pre-existing Part 26 CA06 scheme of arrangement (the “Scheme”) but differing via the existence of a “cross-class cram down” mechanism which enables the court to sanction a Plan even when creditor classes dissent, as long as certain conditions are met. In another departure from the Scheme, it is a prerequisite that the proposing company must demonstrate that it has encountered or is likely to encounter financial difficulties likely to affect its ability to carry on business as a going concern. The purpose of any restructuring is to resolve or mitigate the effect of a company’s financial difficulties, typically requiring compromise on behalf of creditors. The nature of the compromise and its effect on various classes of creditor are driven by the enterprise value of the company – and in situations where value breaks within the creditor stack, creditors either side of the value-break are likely to have differing perspectives on whether a proposed restructuring arrangement is in their best interests or not. It is typically junior secured or unsecured creditors that bear the brunt of compromise and thus a significant proportion of them may be inclined to vote against a proposal. The cross-class cram down mechanism aims to provide the Restructuring Plan with a practical solution to this, in that the Plan can be sanctioned by the court provided that (i) one “in the money” creditor class (most likely senior secured lenders) votes in favour, and (ii) that any dissenting creditor class is estimated to receive more under the Plan outcome than in the “relevant alternative”. In some cases junior creditors may be the approving class, potentially leading to situations where approval is used to cram down (or “cram up”) a more senior creditor class, impinging secured rights. The relevant alternative is defined as “whatever the court considers would be most likely to occur in relation to the company if the compromise of arrangement were not sanctioned”. Whilst the definition is intentionally broad, the relevant alternative is the fulcrum of a Restructuring Plan – understanding value under this counterfactual scenario is central to demonstrating a Plan’s fairness, and ultimately in determining the court’s willingness and ability to sanction it.

The valuation of alternative and illiquid investments – such as privately held companies – is complex and highly subjective. The depth of challenge and degree of subjectivity are exacerbated during times of economic uncertainty and further still when the subject company is directly facing operational or financial distress – an entry requirement for companies proposing a Plan. The overall valuation exercise that supports a Restructuring Plan is fundamentally comprised of three steps:

Virgin Atlantic Airlines: September 2020 First plan to be sanctioned Relevant alternative: Orderly wind-down Pizza Express: November 2020 First plan to involve a debt for equity swap Relevant alternative: Group-wide liquidation Deep Ocean: January 2021 First plan to utilise the cross-class cram down mechanism Relevant alternative: Administration or liquidation

Determining the relevant alternative

Valuation of the company under the relevant alternative

Comparison of creditor outcomes under the Plan and the relevant alternative

4 Gategroup: March 2021 First time a court decided whether a restructuring plan qualified as a civil/commercial or insolvency matter Relevant alternative: Insolvency 5 Premier Oil: March 2021 First example of a restructuring plan being utilised by a listed company Relevant alternative: : Group-wide liquidation 6 Smile Telecoms: March 2021 First plan to exclude shareholders and all bar one class of creditors Relevant alternative: Sale of assets from insolvency 7 Virgin Active: May 2021 First fully opposed cross-class cram down judgment and the first to include landlords as dissenting creditors Relevant alternative: Trading administration and accelerated sale Hurricane Energy: Declined in June 2021 First plan to be declined. Court found that shareholders would be better off if the plan wasn’t sanctioned Relevant alternative: Orderly wind-down 8 Amicus Finance: August 2021 First restructuring plan to be proposed by a mid-market company and first used as an exit from administration Relevant alternative: Liquidation 9 ED&F Man: March 2022 First plan to use the cross-class cram-down in a financial creditor class and to amend articles of association Relevant alternative: Partial liquidation, partial divisional share sales 10 Houst: July 2022 First plan to be sanctioned for an SME where the company was not already in a formal insolvency process Relevant alternative: Pre-pack administration

Soundings from the first 10

Following the sanctioning of the first 10 Restructuring Plans (see below) it is clear that the estimated value under the relevant alternative is a key consideration in judgements, and an area of potential dispute between creditor classes. A review of the cases so far reveals three key themes that stand out from a valuer’s perspective – the need for (i) debate, (ii) depth, and (iii) disclosure.

The purpose of any restructuring is to resolve or mitigate the effect of a

company’s financial difficulties, typically requiring compromise on behalf of creditors. Chad Griffin Restructuring Advisory

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CIGA Restructuring Plan: A valuer’s perspective 10 plans in

Depth

Debate

The importance of the relevant alternative valuation to the sanctioning of a Plan necessitates a deeply considered and robustly supported valuation process. Value is often professed to be what a ‘highest bidder is willing to pay’ and whilst this is not an unreasonable description, determining that amount is is rarely a straight-forward exercise. A market testing exercise – where an indication of value is sought through an auction or sale process – is often not feasible for a company looking to enact a Restructuring Plan, not least due to the myriad of complicating factors and likely time constraints, but also as potential bidders may not conduct the necessary enquiries or due diligence required to put forward a reliable offer if they are aware of or suspect a shadow-testing exercise. As such, the valuation supporting a Restructuring Plan will typically take the form of an independent estimate of value based on ‘desk-top’ analysis prepared by a firm of valuation experts. The Virgin Active judgement demonstrated an acceptance that a ‘desk-top’ valuation exercise is appropriate with the Judge stating that there was “no absolute obligation” to undertake a market testing process and finding “no basis upon which to impugn” the desk-top valuation that was put forward, despite challenges from certain creditor groups. Notwithstanding this, it should not be lost that a desk- top exercise is an attempt to estimate the outcome that would be achieved (i.e. the value that would be recovered) if a genuine market testing exercise were able to be undertaken within the prescribed set of parameters – as defined by both the relevant alternative itself, and the state of the market at the relevant time. Thorough examination of the valuation should be expected. The valuation supporting the Smile Telecoms Plan was “interrogated at length by the senior lenders and their advisers”, whilst Premier Oil’s submission came under “considerable scrutiny”. Add to this that the Hurricane Energy Plan was rejected, and that further valuation analysis was requested by the court in respect of the Houst valuation (following opposition from HMRC), and it is clear that depth of analysis is essential and a range of approaches should be considered.

The relevant alternative is what the court considers to be “most likely” and this should not be pre-judged at the outset. The variety of alternatives accepted in the cases so far (and the one rejected) demonstrates that establishing the appropriate relevant alternative requires thorough debate and consideration in respect of what is most likely to occur in the absence of a Plan. It may be the case that the closer the company is to immediate cash-flow insolvency, the more likely it is that the relevant alternative is liquidation or administration, but any exercise should consider the full breath of possibilities and both the conclusion and thought process should be robustly supported. It is evident that the court values the input of a company’s directors, with the Judge (ED&F Man) stating “the court should recognise that the directors are normally in the best position to identify what will happen if a scheme or restructuring plan fails” and Judge Wolffe (Premier Oil) placing considerable weight on the fact that [the directors] had first-hand experience of the challenges in developing and negotiating a previous transaction and attempted restructuring arrangement. Whilst establishing the relevant alternative is part of the wider valuation exercise, it requires input and insight from outside the valuation spectrum including discussion and debate involving the company’s directors, legal, and financial advisers, as well as recognition of the paths trodden under both Schemes and CVAs. It may be necessary to approach the selection of the relevant alternative as an iterative process, as the most likely alternative scenario may be in part determined by which of a range of possibilities is estimated to be value maximising (which would itself be informed by the valuation analysis). Failing to explore a range of possible alternatives may leave a process exposed to challenge, criticism and dispute.

The importance of the relevant alternative valuation to the sanctioning of a Plan necessitates a deeply considered and robustly supported valuation process. Jim Davies Corporate Finance

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CIGA Restructuring Plan: A valuer’s perspective 10 plans in

CIGA Restructuring Plan

Valuation approach

Market approach

Disclosure

The valuation of a company or asset is generally undertaken using a combination of three approaches – the income, market and cost approaches. No approach is by definition superior to another and a key part of a valuer’s role is selecting what combination of approaches is best suited to a given company in a given situation. Incorporating all approaches in some form is generally considered valuation best practice. The valuation should be of the company ‘as is’ reflecting the circumstances facing the company, as opposed to a valuation of the company following a successful restructuring. The nature of the relevant alternative will influence the choice of methodologies adopted and key benefits and limitations of each need to be considered.

Before making a decision to sanction a Plan – particularly one excluding or compromising certain creditors via a cram down - the court will want to be comfortable that all parties have had ample opportunity to interrogate and challenge the evidence and recent cases demonstrate that broad and early disclosure of the valuation analysis is valued by the court. In Smile Telecoms, the valuation and comparator analysis were provided to all parties to the Plan (and other stakeholders), subject to confidentiality agreements. The court took a great deal of comfort that the evidence had been shared early such that affected parties had sufficient time to consider their position. Similarly, in ED&F Man the relevant alternative and Plan outcome reports were disclosed in full to all creditor classes with the open approach being commended and the judge referncing an “informative report which provides clear evidence as to the financial consequences for the dissenting class in the event of the relevant alternative scenario.” It is also apparent that fullness of disclosure is valued, particularly in large or complex cases where a stand-alone narrative report supported by detailed schedules and outcome statements may be necessary for stakeholders and the court to make well informed decisions, as was noted in the ED&F Man case. A more summarised form of disclosure may be sufficient when it comes to SMEs accessing the Restructuring Plan, with courts showing a pragmatic approach in the Houst case, recognising the cost implications to smaller companies and striking a balance accordingly. In time a streamlined version of the Restructuring Plan may take shape for smaller companies, potentially reducing the process to one court hearing and driving further focus on the valuation exercise in order to minimise appeal processes.

The market approach relies upon establishing a maintainable level of earnings (typically EBITDA) and applying a market-benchmarked multiple (typically Enterprise Value / EBITDA) that reflects the market’s current pricing of companies vs their maintainable earnings. The approach’s principal benefit is the direct reference to live (or recent) indicators of market pricing, which is a vital consideration in any valuation if such pricing information is deemed to be reliable and sufficiently comparable. Challenges include determining a maintainable level of earnings before interest, taxes, and amortization (EBITDA) for a company going through a period of distress, and suitably adjusting multiples observed from comparable transactions or listed companies that are likely facing a different set of challenges, opportunities, growth prospects and risks. The market approach faces additional complexities during recovery from a global economic shock, such as the Covid-19 pandemic as valuation multiples remain skewed by the widely varying impact of the crisis on different companies (even within the same sector). Particular care must be taken in selecting comparable companies and adjusting multiples, whilst further modifications may be required to reflect cash-flow differences driven by factors such lower cash-conversion, working capital shortfall and capital expenditure catch-up.

Income approach

The income approach (most commonly applied as the discounted cash-flow methodology) has the benefit of being able to directly incorporate company and situation-specific factors into the projected cash-flows from which value estimates are derived. These include factors that financially distressed companies may face such as the risk of losing customers (who may seek alternative suppliers without going concern risk), working capital squeeze, tightening of capital investment plans and the risk of losing key personnel. Industry-wide factors such as changing demand, supply chain challenges and inflation in energy, commodities and wages can also be explicitly incorporated as deemed appropriate. A further plus-point of the income approach is its flexibility – being able to incorporate a variety of scenarios and sensitivities to demonstrate the impact on value of changes to selected inputs and assumptions. It can be well suited to assessing value under a range of possibilities, adding depth to the justification of the relevant alternative and why other possibilities were rejected or deemed less likely to unfold. Challenges with the income approach relate to the uncertain nature of cash-flow forecasting and appropriately assessing investor perceptions of risk. The relevant factors can be incorporated via direct adjustments to forecast cash-flows, risk-premia included in the discount rate, or an overall adjustment reflecting the impact of financial distress supported by statistical studies.

Cost approach

The cost approach is based on the assets that a business owns, and the value that would be received from their sale (or alternatively, the cost that would be incurred to replace them like-for-like). This approach is typically seen as a ‘value floor’ for unstressed businesses where going concern value may be greater than the aggregate value of on-balance sheet assets due to the contribution of intangible assets and goodwill to the earning power of the business. However, companies in operational or financial distress may find the value of their intangible assets and goodwill to be largely or entirely impaired, with value being upheld by the underlying assets that could be disposed of (collectively, individually or in groups) for a greater return than would be achieved in a going concern sale. The extent of reliance on the cost approach may be influenced by the definition of the relevant alternative – it may be of primary importance in a liquidation or solvent wind-down, whilst serving as a secondary measure or sense-check in an assumed sale of the business as a whole or in sub-divisions.

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CIGA Restructuring Plan

Conclusion

10 Plans in and it is evident that the onus is firmly on the company proposing a Plan to provide evidence that the ‘no party worse-off’ test is passed, which centres around the relevant alternative valuation exercise. Whilst process and best practice may still be taking shape, it is clear that: Broad consideration of the possible alternatives based on insight from the best-placed and best-informed parties is expected Valuation analysis should be thorough, technically on-point, commercially rational and robustly supported with outcomes clearly demonstrated Full and early disclosure is valued by the court and sharing with all materially impacted parties may become the norm

Full and early disclosure is valued by the court and sharing with all materially impacted parties may become the norm. Phil Reynolds Restructuring Advisory

About FRP

FRP has a dedicated valuation team that has conducted numerous independent valuations in support of domestic and international restructuring processes and a team of restructuring, insolvency, and corporate finance advisers with considerable experience of advising and trading companies through processes, and realising value through accelerated sales, liquidation and other means. We recognise the importance of bringing the right blend of experience to a particular situation, and ensure that consideration of the relevant alternative, understanding of the practical realities of complex and uncertain exit strategies, and the valuation analysis itself are led by the right advisers.

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September 2022

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