Restructuring Question (Comparables, WACC)
I'm writing up a study guide for banking/restructuring as I go through interviews etc.
First of all, how does one select comps for valuing a distressed firm? In an ideal world, other distressed firms in the same industry would be the most representative, however this is rarely available. Should it be based on filtering industry comps by leverage and seeking the ones that represent the firms financial structure the closest? Can you look at other industries for distressed firms and weight them? Should you select regular comps, but then introduce distressed assumptions?
Second, regarding the WACC:
For valuing a distressed firm, I'm having trouble understanding the WACC you want to use. Can anyone let me know which option is correct?
The WACC will increase when a firm is in distress as the credit risk associated with the firm skyrockets. The cost of debt increases as the likelihood of distress increases with bankruptcy probability. The cost of equity increases as equity holders associate higher bankruptcy probability with higher risk, in turn, requiring a higher return. In an ideal world, have a different WACC for each period as the capital structure swings, but normally, a DCF uses the same WACC based on a long-term capital structure, which may overvalue the firm. A DCF based on a highly levered firm’s WACC will undervalue the firm.
Options for Cost of Debt:
1) Market rate of debt for firm (high since distressed, skewed upward)
2) Book value of debt (skewed lower since debt was raised when in better condition)
3) Yield-To-Maturity (but it’s based on promised cash flows rather than expected)
4) Default Spreads on Bond Ratings (risk-less is up for discussion)
Options for Cost of Equity: (Beta within CAPM)
1) Regression Beta (but lags distressed performance since its derived over long periods)
2) Unlevered Beta (good since it represents the highest required return for the class that’s been wiped out. A subordinate debt claimant is now considered “equity”.
3) levered beta (need to use long-term debt/equity ratio - firm expects to reach this ratio in the long-term)
Since the capital structure of the firm is volatile in the first few years after restructuring, as leverage decreases, it can be difficult to find a single WACC to use.
So my question is...is it best to use the levered Beta for cost of equity (unlevered industry beta, relevered to company beta), and the default spread on the company’s bond rating plus the market rate for similar debt, for the cost of debt? My issue here is that the cost of equity is based on a long-term picture, while the cost of debt is based on current firm distress.
*when I say market rate of similar debt above, it's assuming the firm is not distressed; hence the bond spread brings in the distressed aspect of cost.
1) Comps Look at firms in the same/similar industry with a similar leverage ratio, like firms who are also in distress. Sometimes you may not find true comparables so you need to relax you criteria
2) WACC For cost of debt use the current yield on the firm debt by using its actual market value. For BETA use levered beta, the D/E ratio can either be the target or the average D/E for the distressed firms (obviously unlever it and then relever it)
Not sure I understand this. If the firm needs to be reorganized, wouldn't the wacc that matters need to be based around a feasible post-reorg capital structure? Also in your answer, if the firm is deeply distressed, isn't target's debt/equity going to be roughly 100%?
You are right. So it would be more appropriate to base the wacc on a feasible post-restructuring cap structure. For cost of debt I would take the average for similar firms (similar to the target post reorganization) and for the beta I would take average beta for comps (same comps as for the cost of debt) and I would lever it using a target cap structure.
I've been doing some more digging and briefly spoke with someone in restructuring, so I'll write what I found out.
1) Comps Yeah, ideally other distressed firms in the same industry with similar margins is the best, but the data is hardly ever available since distress isn't often a frequent enough event to have a perfect comp set. Therefore one must take what would actually be a normal comp set. For example, if you have a distressed telecom firm, Sprint/Verizon may still be in there. Valuation will be done based on the EBITDA that's been adjusted for working capital, one-off advisory fees, COGS, CapEx, etc. The firms lower EBITDA, relative to previous years, is how the firm is currently performing (which is worse than before). Aim for the lower ends of the comp multiples.
2)WACC This will depend on where you stand in the capital stack. Different investors/creditors will argue for different valuations to maximize their return or control. Cost of Debt: Use default spreads at current market yields (depending on where you are on the capital stack, some investors/advisers may use the YTM, comparable bond spread, and comparable market rate with various assumptions) Cost of Equity: levered beta per your capital stack using long-term D/E ratio (again, depends where you sit on the capital stack or who you're advising)
*Then do a liquidation analysis for both.
The post above is correct however, you have to remember to adjust line items such as A/P and A/R to reflect the distresss. Also, bear in mind if the restructuring is being done in court or out of court because the costs asscociated are vastly different. I would make a market value B/S to reflect what the current debt is trading at (or what you have negotiated in a pre pack) to reflect the new equity cushion. When you do this you will have negative shareholders equity reflecting the distress and this is where you commence to "restructure" he balance sheet. Your WACC will change due to this and in regards to your valuation you can do a liquaidation analysis (fire sale) or comps for previously acquired distresss companies. Hope this helps.
Would the market value B/S be based on liquidation recovery pricing, or interest/coupon bond pricing?
Could you did more into "Your WACC will change due to this"?
Market value B/S would be based on what the new debt is trading at i.e. 86,95,64. (Essentially bond pricing)
WACC- look up the yield for the current debt reflecting its current state. Remember the previous WACC is prior to the distress thus, the new cost of debt needs to reflect this. The CAPM take a bit more creativity because you will need to unlever and re lever the beta (similar comps) to reflect the new risk in the company.
Remember the valuation will always be based on who is conducting it (which debt holder/ tranche) and submitting it to the court. Most of the time it will be purposely conservative and at the expense of a particular class. This gives way to a windfall, which occurs sometimes usually at the expense of the subordinate debt or equity holders.
I'm still confused about cost of debt - let's say you have a company in chapter 11 and you are trying to value the enterprise, and need a WACC. For simplicity, if there is one class of debt and it is trading at 50 and was originally scheduled to mature in 2 years with a coupon of 10, are you saying some people would have cost of debt as the ytm, or over 50%? That seems like it would massively understate the value of the enterprise.
To arrive EV you wouldn't need WACC just the market value balance sheet.
In your scenario if the debt trading at 50 about to mature is senior unsecured then it's trading down because of the inability to refinance. Therefore, all the debt subordinate to it will be trading down even further because typically the covenants will not let subordinate classes receive payment if a debt more senior to it is in default.
Remember the cost of debt is what would it cost you today to issue debt based on the current credit. So you would look at what a current unsecured bond with a similar rating/distress would cost to issue or is currently trading at.
1.Isn't the EV proposed in a chapter 11 usually going to be different from the cumulative market prices of debt and equity? I think you're calculating market EV (starting with the equity and adding liabilities), but I'm talking about estimating intrinsic EV (starting with the valuation of assets through either multiples or future fcf, and subtracting liabilities). If the only EV calculation necessary was market EV using a market BS, how would anyone investing in distressed credit ever have a valid investment thesis?
Well yeah I guess. I'm thinking about a company's debt that is almost certainly not going to be performing (either in chapter 11 or likely to file shortly), so I would think current market price would be reflective of expected recoveries in a por.
This definition of cost of debt seems virtually meaningless if the credit is in default or inevitably will be, as it wouldn't be priced off of ytm at that point but rather expected recovery.
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How do you calculate WACC here? Cost of debt and equity? How about EV? Impact on Risk free rate?
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