Each and every solvency opinion is subject to a unique analysis since the solvency opinion is – by definition – only applicable to one, single, unique business entity. As such, there are no “hard and fast” rules of thumb to apply to completing a solvency analysis. To the extent this article uses numbers and examples, they are only hypothetical and only for discussion purposes.
Company boards often seek third-party solvency opinions in connection with leveraged transactions to assist them in fulfilling their board duties. In furtherance of their duties, board members may find it helpful to review what constitutes a competent and thorough solvency analysis. It is critical for a board to seek an experienced, third-party provider who can not only illustrate full breadth and depth of its solvency analysis capabilities through a comprehensive and extensive list of clients but also have the ability to defend their opinion in the event of future litigation. A good solvency analysis will provide a board with the third-party provider’s opinion that reasonably concludes as to whether a company is solvent and will have adequate capital in a leveraged financing transaction. In this article, we examine some of the key factors company boards should evaluate when relying on third-party solvency opinions for leveraged transactions.
Company boards may seek to obtain an outside solvency opinion for:
- Leveraged buyout (LBO) deals where leverage is significant
- Public company share repurchase programs
- Dividend recapitalization transactions
In approving these types of transactions, boards should ask their legal counsel whether a third-party opinion is recommended and if it would assist in defending board members against future potential liability claims when performing their fiduciary obligation associated with a transaction. Boards should consider the following questions when evaluating a solvency opinion provider:
- Does the firm regularly provide solvency opinions?
- How many opinions have they previously provided?
- How long has the firm that is providing the opinion been in business?
- Has the firm successfully defended its opinions in the past?
- Will the firm advise you against consummating a transaction if it is not appropriate?
Economic and Industry Risk Factors
The provider of a thoughtful solvency opinion analysis will always want to understand the subject company’s business sensitivities to the general economic cycle and current industry trends. A key question is whether the overall industry is expected to grow or contract over the forecast period. If industry trends are positive and the market is expected to continue growing, this provides a favorable context for a leveraged transaction and should be documented in the solvency opinion analysis.
In addition to industry trends, there are a variety of company-specific factors to consider when approving a leveraged deal and assessing the quality of the solvency opinion analysis. It is equally if not more important than evaluating industry trends to understand long- and short-term trends in company performance. A board should be aware if long-term trends (i.e., several years in retrospect) and current trends (i.e., latest available quarterly information) are positive and upward or negative or downward, as well as the principal drivers of the trends. A recent spike in company growth or profitability should also be reviewed. The board should ascertain whether a recent performance improvement is expected to be permanent or temporary, which, in the latter case, may likely revert to levels aligned with historical trends.
A second factor to consider when reviewing company trends is whether the company has a track record of successfully reducing debt or deleveraging. Companies that have demonstrated the ability to delever over time are may be more capable of operating effectively under a significant debt load.
Finally, it’s important to know whether the proposed increase in leverage leads to a downgrade in the company’s credit ratings. A decrease in credit ratings often occurs in leveraged transactions and does not necessarily indicate insolvency, but may require additional inquiry.
One of the key solvency tests assesses whether there is adequate equity cushion remaining in the company after giving effect to the leveraged transaction. Equity cushion refers to the excess of assets over liabilities by some reasonable amount and is defined as enterprise value, plus pro forma cash, less pro forma debt. This amount needs to be positive. Cushion is generally measured as a percent of total invested capital. However, another way to assess the cushion is to compare the valuation multiple to the leverage multiple. For example, if the company has a valuation multiple of 7x earnings before interest, tax, depreciation and amortization (EBITDA) and is 5x levered, then this implies an equity cushion. However, the leverage multiple alone does not tell the whole story. The relative enterprise valuation needs to be considered. For example, two deals may have the same leverage multiple at 6x EBITDA but may have different solvency risk profiles. If the implied valuation multiple is 7x EBITDA for Company A and 10x EBITDA for Company B, then Company A has less than 15 percent equity cushion while Company B has 40 percent equity cushion.
The primary financial metric used for valuation in most leveraged deals is pro forma adjusted EBITDA. After the relevant pro forma adjusted EBITDA (or another appropriate financial metric) is identified, the next step is to select a multiple or range of multiples to apply to that metric. Pricing indications can be based on the trading multiples of comparable public companies and on the multiples paid for comparable target companies in M&A transactions.
A discounted cash flow (DCF) analysis is another primary valuation method to derive the enterprise value in a solvency opinion analysis. There are a couple of important factors in this approach. First, the value indication from the DCF analysis is highly dependent upon the nature of the financial forecasts used – the higher the forecasts, the higher the value and vice versa. The second element to analyze is the derivation of the terminal value. In many DCF models, a substantial portion of the overall value comes from the terminal value. There are two primary methods used to calculate the terminal value, also called residual value, in a DCF analysis: the exit multiple method and the perpetuity income method. The perpetuity income method represents the value of the future cash flows of the company into perpetuity assuming a certain long-term growth rate. When this method is used, the DCF represents a pure income approach. When the exit multiple method is used, the DCF analysis really becomes a hybrid approach – a mix of an income-based approach and a market-based approach.
Solvency opinion providers will often compare the overall multiple implied by the solvency valuation to the original entry multiple paid by the sponsor firm if the transaction is current. If the multiples are materially different and particularly if the implied solvency multiple is higher than the entry multiple, it is useful to understand the reasons for the difference. An increase may be justifiable for a number of reasons including that there is an observable improvement in trading multiples for comparable public companies or industry M&A multiples or both. If the company has completed a number of add-on acquisitions since the original platform deal, this could also justify a higher multiple due to the company’s increase in size.
Cash Flow Testing
The second key solvency test is the cash flow coverage model, which verifies if the company will have adequate cash flow going forward under the new debt load to operate the business and make its principal and interest payments. A prudent solvency opinion analysis will perform sensitivity analysis on the financial projections to see what kind of downside scenarios the company can weather and still make its principal and interest payments when due and comply with any financial covenants.
The bank case financial projections will not always extend out beyond the maturity of the debt. Although it is preferable for the model to go until complete debt payoff, this is usually not the case. A factor that may be reviewed is whether one may reasonably expect the company to be able to refinance its debt when it matures or comes due. An improvement in credit statistics during the forecast period may be an indicator the company could do so.
While the valuation approaches and underlying assumptions used in the context of solvency opinion analysis are in line with those normally employed in a number of other valuation assignments, one must identify the operational and financial risks of the subject company and evaluate those risk factors to adequately measure equity cushion and cash flow generating capacity should those risks materialize. Each company has its own weaknesses and vulnerabilities, and boards need to ensure the solvency opinion provider they select has fully accounted for them in developing an opinion.
VRC was one of the first providers of corporate transaction opinions. We have issued over 1,000 fairness, solvency and capital surplus opinions for transactions valued from $10 million to over $10 billion in market capitalization. For a more in-depth conversation and information regarding our opinion practice, we invite you to contact your VRC professional.