Walk me through a waterfall valuation

That's a pretty tough question honestly, and I wouldn't expect it in anything other than an experienced hire interview because it's so easy to get something materially wrong. That said, I'll take a stab at it.

Assuming that we're modeling a company emerging from Chapter 11 with a plan that doesn't use substantive consolidation, the first step is to create a detailed org chart of the company, its consolidated subsidiaries, and any equity method investments. For each of these companies, we need to obtain consolidating financials so that we can determine the assets available for each claim. These assets need to include not only the typical operating assets plus cash, but also any inter-company assets including receivables, loans, leases, and stock. We can value the operating assets with any type of valuation method (multiples, DCF, etc.), and we can calculate how much cash has been built up during bankruptcy using a liquidity projection. Inter-company assets we'll value in the waterfall.

The next step is to determine the claims against each company again on a consolidating basis, so we'd look to a cap table, credit, and security agreements to determine third party debt obligations including their primary and secondary obligors, security interests, and contractual subordinations. Claims would also include things like pre-petition payables, lease rejection claims, and rejected pension claims as well as inter-company claims.

With those steps complete, we start our waterfall model with operating companies at the bottom of the org chart without any inter-company assets. We can begin to distribute the value of the company assets according to the usual order in the Bankruptcy code (DIP, Secured Debt, Administrative Expenses and pre-petition taxes/wages, Unsecured Debt, subordinated debt, preferred equity, common stock). At each step, if there is enough value to allocate to the claims, we subtract the value of the claims and waterfall value to the next step down. If there is not enough value to cover the step, we allocate value to each claim at the step pro-rata according to claim size. For the secured step, we need to determine if the value of the collateral backing the debt is enough to cover the secured claim with any deficiency being treated as unsecured debt. If any value remains for common stockholders, we count that as an asset for the parent company. Also, because any inter-company asset is also an inter-company liability, once we determine the recovery for the liability, we know the value of the asset which allows us to work our way through the inter-company dependencies. We can then repeat this waterfall process for each company in our org chart. We then sum up the value of the recoveries at each company for each piece of debt which gives us an aggregate recovery dollar value.

The final step is to determine the form of consideration for each claim (cash, debt, equity, etc). Because we know the value of the assets of the company, we know the value of any debt and equity for the reorganized company, and we distribute this consideration according to the plan of reorganization so that the value of consideration is equal to the value of the recovery. While all of this is plan specific, we typically give cash and debt to the most senior claimants and equity to more junior securities. Our final valuation table should show for each claim, the claim amount, the dollar and percent recovery, and the dollar amounts for each consideration paid to the claim.

Someone can correct me if I've done something wrong but this is the jist of it. While that's a long answer, I would think it's important to demonstrate that you understand the inter-company aspects (when companies file for bankruptcy, there are technically multiple bankruptcies that each have their own waterfalls) in addition to the usual structural subordination and absolute priority structure.