What Makes a Liquidation Analysis Realistic?
The annual number of bankruptcies peaked at 60,837 in 2009, but the financial and bankruptcy experts expect the level of bankruptcy filings to explode well over that peak during the next twelve to twenty-four months. During the first six months of 2020, there were 3,604 business bankruptcy filings, which is up 26% from the 2,855 filings during the first six months of 2019 (Epiq/Aacer). June year over year chapter 11 bankruptcy filings increased 43% from 2019 to 2020. The June increase is expected to be the start of a wave of business bankruptcy filings as the economic impact of the Covid-19 virus manifests itself in lost businesses.
This anticipated increase in bankruptcy filings means lenders will be challenged to manage an increasing number of borrower relationships during the bankruptcy process, including developing or evaluating various liquidation scenarios.
Lenders will be challenged to anticipate recovery values under different liquidation strategies – ranging from different bankruptcy proceedings, to receiverships, to ABCs, to out of court wind down processes.
The lender and its advisors will be challenged to use existing information to address current and future recovery expectations. During this analysis, there are key areas to consider.
Lenders, borrowers and their advisors will need to focus on these key items:
Recent appraised values,
Current industry and market trends,
Recent business performance, and
Costs to move through a liquidation process.
Recent Appraised Values
When evaluating appraised values, the following questions should be considered:
-Review appraisals that have been completed over a period of time. For example, if annual appraisals are required, review three years. If quarterly or semiannual appraisals are required review at least two years of appraisals. This should help identify changes in the collateral valuation and liquidation cost estimates prepared by the appraisers over time, which in term will inform the reader of the most current appraisal about areas to consider for additional evaluation.
-Review the appraisers’ estimate of time to convert to cash. Appraisers use terminology differently and some are more clear than others when discussing timelines. Be sure to understand the time to achieve orderly liquidation and forced liquidation values. That will be important when evaluating the costs to achieve the recovery.
-Determine which operating and deal costs the appraiser has netted out of the recovery values and which operating and deal costs are not netted out. It is important to understand these costs because the liquidation analysis will need to test the completeness of the costs, and the amount of the costs.
-Identify the degree of detail used for valuing complex and evolving assets such as inventory. Areas that may be treated differently in appraisals are:
Turnover by SKU.
Estimates of the relationship between raw materials, work in process and finished goods.
The expectation to complete work in process inventory.
Evaluation of contracts to purchase inventory.
-For real estate, consider the time estimated to a complete a sale, and then evaluate the operating and deal expenses for amount and completeness. Areas to consider include:
Costs to mothball the facility.
Costs to provide utilities to the facility during the sale process.
Costs to maintain clear title, including taxes, assessments, and environmental approvals and certifications.
Appraisals can be completed in a variety of different ways and meet the requirements for a certified appraisal. The same asset could be appraised at different values by multiple appraisers as of the same date, and each appraisal would be acceptable to a lender.
As a lender, the important factor to consider is that appraisals are estimates. The estimates are based on assumptions. Appraisers provide varying degrees of detail in the assumptions used to develop values, and that detail is critical to a lender and its advisors when preparing a liquidation analysis.
Current Industry and Market Trends
Even an appraisal completed in the last month is aged in many ways which will be important to the lender or its advisors when evaluating liquidation values. Macro and micro economic considerations need to be considered. Areas to consider include:
In a situation such as the one created by Covid-19, appraisers may have negatively impacted values based on a macro situation, even though the micro economics of a borrower or its industry are more or less impacted.
Different regions have been affected differently. Consider a restaurant in NYC that is being told it will not be able to open for inside dining until at least 2021, compared to a restaurant in Georgia that is open under certain conditions.
Downtown areas are experiencing the impacts of Covid-19 and the looting/rioting.
Consider the different state, county, city and federal guidelines all relating to a specific business just for Covid-19.
Key to evaluation of liquidation values is the specific business, its industry, its regulatory environment and its geographic location.
Recent Business Performance
The recent performance of a business impacts the appraised value. Consider a business that has sold slow moving inventory to generate cash. If the appraisal included an estimate for slow moving inventory before that sale of inventory occurred, the inventory value used in the liquidation could be understated. Conversely, if a business has had difficulty sourcing raw materials or product for sale, the mix of inventory by components or by SKUs may be negatively impacted and the liquidation value could be overstated.
Assumptions are risky when used to determine working asset levels during a liquidation. Real time information for accounts receivable and inventory has to be evaluated. In situations where a weekly cash flow and borrowing base forecast is provided, the most current information in the actual results and forecast should be used. Also with the benefit of the cash flow forecast, liquidation estimates at various points in time should be considered.
Consideration also has to be given to the delivery of inventory from both a timing and dollar amount perspective. The evaluation of potential claims suppliers may be able to assert is important as those dollar amounts could be material to a recovery estimate.
Reviewing the appraisals, the budgets, and the current financial statements is required to triangulate the information and correctly assess liquidation value ranges.
Costs to Liquidate
The costs to liquidate assets need to be developed on an asset by asset basis as well as an overall approach to business operating expenses.
The costs identified in the appraisals must be considered in conjunction with run rates of expenses to ensure all expenses are accounted for and that there is no double counting of expenses.
Liquidation expenses should be considered in these areas:
-Staffing: A week by week, department level plan needs to be developed down to the individual staffing levels.
PTO and other benefits such as health insurance need to be considered.
Legacy staffing costs, such as accrued vacation, must be evaluated.
Consideration needs to be given to outsourcing or staffing services to complete tasks.
A contingency plan should be developed to ensure essential work will be completed during the liquidation period.
Stay bonuses and performance incentives should be considered to ensure liquidation recovery estimates are achieved.
Utilities. Consider minimums or contracts to purchase a defined level of service.
Maintenance and repair costs should compared to recovery impacts.
Taxes – real and personal property – must be scheduled and then evaluated payment strategy.
Security. Both onsite security staffing and security systems should be considered. Fire monitoring systems, flood monitoring systems, equipment malfunction monitoring systems, and any other monitoring systems should be considered. Regulatory requirements for those systems should be considered, in addition to considering the impact on preservation of value.
Equipment required to move inventory and equipment may need to be retained, or rented. Consider the ability to sell “as is / where is”.
Consolidation of locations should be considered when evaluating inventory, accounts receivable and staffing, as well as when evaluating real estate recovery values.
Costs to maintain data electronically and in paper will need to be considered.
Ensuring access to data may be complicated. Both data and systems themselves must be accessible. Passwords and system administration access will need to be evaluated.
Storage costs, both physical and electronic, during the liquidation will need to be forecast.
Retention requirements and costs after the liquidation may be necessary. Determining those costs may be important to the recovery.
-Commissions and Fees
Account for all sale commissions and fees – both internal and third party. Make sure to understand what is and what is not included in the net recovery appraised values.
Access to the ability to sell inventory to customers may require trucking, shipping costs, or 3PL services.
General liability coverage will need to be in place during the liquidation.
Asset coverage is also necessary.
D&O coverage, including tail coverage, should be considered.
-Warranty claims and related issues.
Asset values may be impacted by historic or future warranty claims.
Bankruptcy cases do not have certainty of outcome. Evaluating the range of recovery options coupled with the costs to complete each approach is required.
Proper evaluation of the liquidation recovery estimates and costs is a necessity in conjunction with the review of appraisals and cash flow forecasting, and estimates of the levels working assets and liabilities.
Alternative Liquidation Budgets
When evaluating a liquidation budget, several time frames and strategies need to be considered.
Liquidation budgets should be developed using these approaches:
Fastest liquidation possible approach. An immediate liquidation is not immediate. There is a time line that needs to be considered and there will be deal costs and operating expenses even under the fastest liquidation approach. The impact on recovery values may be positive or negative. Performance risk must be considered. This liquidation approach should be the fastest time line that could be achieved.
Measured approach. This approach provides for operations during a limited period with an eye toward improving working asset recoveries. Contingency plans will be a key part of this approach, as staffing and inputs may change in real time. Deal and operating costs will require more scrutiny and detailed planning. This is an aggressive but measured approach to a liquidation.
Longer term approach. This approach may include continuing to operate the business through a period to a sale. It may consider the impact of the time required to convert property, plant and equipment to cash via auctions, shorter term listing arrangements, or full scale marketing efforts of one year or more.
In many situations a combination of these approaches should also be evaluated. For example, the fastest liquidation approach compared against a measured approach for working assets, and a longer term approach for real estate and equipment, may be an alternative that maximizes value.
As part of each of these liquidation budgets, performance risk should be considered. The longer the timeline to recovery is extended, the more risk the lenders will experience. Outside factors, including weather, the overall economy, and international situations, may negatively influence an otherwise well thought out liquidation strategy.
What Should the Lender Do?
A liquidation plan is not a certainty. Lenders, coupled with their legal and financial advisors, must consider the various strategic options available. Asking questions and understanding the assumptions will best prepare a lender to deal with the liquidation of a company.
No borrower or its advisors will be able to guarantee a speedy process or specific results. Lenders and their advisors must be prepared for uncertainty and be able to forecast and monitor cash flows (and all of the underling variables) both before and after a bankruptcy filing to minimize costly mistakes. This will also require regular updating and analysis of the liquidation valuation estimates and budgets.
Lenders who are armed with experienced legal and financial advisors to evaluate cash flows and bankruptcy options, including liquidation scenarios, will be able to negotiate, structure and implement liquidity and funding solutions that are most likely to maximize value and recoveries through the bankruptcy process.