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Valuation Challenges in Cross-Border Restructurings by Mohsin Y. Meghji Valuing a company in a restructuring is a challenge at the best of times. One needs to grapple with issues such as a limited track record of cash flow or earnings from the reorganized entity, which leads to valuation debates amongst stakeholders when determining a company’s capital and ownership structure. So what is the value of a company? Simply stated, the value of a company is the present value of its future cash flows, discounted at a rate that reflects the composite cost of financing available to the company from various sources (also referred to as the weighted average cost of capital). Assuming you can agree on a set of financial projections for a restructured company, disputes over valuation will arise due to differing perceptions of risk. These disputes lead to the use of varying discount rates in estimating the value of a company. As the world economy increasingly globalizes, it is very common for companies undergoing a turnaround or restructuring to have to deal with cross-border issues. These can range from "basic" problems such as dealing with foreign suppliers or customers to having to reorganize and value foreign subsidiaries. This article examines some issues that have an impact on cross-border valuation analyses as part of a restructuring. The valuation discussions focuses primarily on discounted cash flow analysis. The Cross-Border Restructuring of The Singer Company One of the more recent cross-border restructurings involved The Singer Company, which emerged from Chapter 11 in September 2000. Singer had operations in over 100 countries in the Americas, Europe, Asia, Africa and the Middle East. The restructuring of this company involved some very complex cross-border issues ranging from dealing with foreign creditors to making business decisions on whether to retain or divest foreign subsidiaries in distant parts of the world. Decisions to retain or divest a subsidiary required detailed analysis of the value of these business operations and an assessment of the business risks associated with doing so. In preparing the business plan of the reorganized entity, every "keep or divest" decision relating to a foreign operation required a series of fairly complex risk and valuation assessments. Basic Valuation Principles and Discounted Cash Flow Before looking at specific cross-border issues, it is worth reviewing some basic valuation concepts in the context of turnarounds. The economic value of an entity is the sum of the value of its debt and its equity. This value is often referred to as the enterprise or reorganization value of a company. A common approach to determining a company’s enterprise value in a turnaround situation is the discounted cash flow (DCF) method using an appropriate risk-adjusted cost of capital. This should be done on a "weighted average" basis taking into account the capital structure on a prospective basis. Typically, the enterprise value of a reorganized entity calculated using the DCF method consists of two main components:
Advantages of using the DCF method include: (1)
Cross-Border Issues Cross-border restructurings, in addition to the basic issues in respect of and criteria for valuations, import special issues and concerns that may have a significant impact on valuations. Many of these issues were encountered in The Singer Company reorganization. Each had to be addressed in order to successfully reorganize the company. Below are some of the more important cross-border valuation lessons from the Singer experience. Foreign Currency Exchange rate fluctuations clearly need to be factored into the projections of any non U.S. dollar earnings. Potential complications in this respect can best be illustrated with an example. A U.S. parent company has a subsidiary in Germany that receives its revenues from England and has a significant supply contract with a French company. Assume also that profits are remitted to the U.S. parent in the form of management fees and dividends. For simplification, assuming that France and Germany have both adopted the euro as their currency, the steps involved in valuing the German subsidiary would include.
The above example, cumbersome as it may seem, is not uncommon and clearly illustrates the complications that currency fluctuations can introduce to a valuation exercise. Of course, a company can always mitigate its foreign currency exposure through hedging, however, this has its costs and is potentially a risky endeavor in itself. Differing Accounting Standards and Regulations While the valuation discussion in this article is based largely on the DCF method, it would be imprudent to ignore the potential impact of differences in accounting standards between countries. Although harmonization efforts continue, these differences are likely to persist for the foreseeable future and, accordingly, must be considered. Another process-related reason is that cash flows are frequently driven off income statement projections that have been adjusted for non-cash items. Therefore, a careful study of the accounting projections is usually necessary in assessing the reasonableness of forecasted cash flows. Accounting areas where there are varying degrees of differences between countries including pension costs, goodwill, asset reserves (e.g. receivables), asset revaluation and foreign currency and taxation-related accounting. A good example of how one of these items can have an impact on a company’s valuation is pension costs. Pension systems and treatment thereof varies greatly from one country to another. Certain countries (e.g. the United Kingdom) require pension plans to be separately managed by pension fund managers. Accordingly, these pension costs need to be funded up front. In certain other countries such as Germany, it is permissible to simple record the pension obligations as a liability and then ultimately pay these out of part of the company’s operating costs. Clearly, these two methods of accounting for and funding pension costs will have a different impact on the respective company’s cash flow and ultimately its value. It is important that accounting treatment issues are thoroughly analyzed and understood and that any factors that will have an impact on cash flow are identified and appropriately factored into a valuation analysis.
Tax Issues and Deferred Taxation Any valuation of a foreign subsidiary must take into account the tax regulations of the subsidiary and parent countries. Frequently, one needs to consider tax regulations in all countries where the parent or any of its subsidiaries do business. International tax planning strategies (e.g. transfer pricing arrangements, management fees, inter-company loans, royalties, etc.) need to be carefully considered and vetted as part of a restructuring to ensure that these are appropriately valued. Deferred taxes, which arise as a result of differences between a company’s financial statements and its taxation returns, may also have a potential impact on cash flow. Certain countries (e.g. Germany) do not allow any differences between these two statements whereas in others (e.g. Canada) the differences could be significant due to accelerated depreciation provisions in the tax regulations. Emerging Market Risks In dealing with subsidiaries or business units in emerging markets, the risk level in a number of respects is significantly higher. In addition to factoring in normal company specific risks relating to business strategy and competitive industry prospects in a developed country, valuations of companies in emerging markets countries need to evaluate, quantify and factor in certain additional risks. These risks include inflationary risk, political risk, foreign exchange controls, regional/geographic volatility, war or civil unrest, regulatory risks, risks of expropriation and poorly-defined/enforced legal systems. The specifics of how one might factor these risks into a DCF valuation model can vary tremendously as these risks could potentially be accounted for either by discounting the cash flow stream or through increasing the risk-adjusted discount rate for cash flows from emerging markets. Since not all of these risks apply in all emerging markets situations, it is important to carefully analyze the real risks and incorporate them in a logical way. In valuing emerging market risks, it is important to take a macroeconomic view of the country or region. These factors will have an impact on valuations from the perspective of investors in these markets much more so than in developed countries. Liquidity Considerations and Existence of Capital Markets More often than not foreign subsidiaries of U.S. companies undergoing a restructuring will be private companies. Depending on the degree to which well-developed capital markets exist, availability of industry and market information may vary tremendously. The absence of a ready market for these companies may also make it very difficult and probably expensive to realize the value associated with such an entity. Each of these factors could have an impact on the value of a private company or one located in countries without well-developed capital markets. In a DCF analysis, due consideration should be given to these issues and value should be adjusted through either the cash flows or the discount rates. Local Expertise and Cultural Considerations Local expertise is invaluable in cross-border valuations. Not only are local professionals more intimately versed in the local laws and practice and thereby add local knowledge to the valuation process, but, as well, local professionals are more likely to have the proper contacts and relationships to complete the tasks at hand. Local experts are also better able to assess hidden value or potential pitfalls that are particular to a local culture. For example, in countries such as Japan, companies can have potentially valuable non-core assets (e.g. minority investments in customers and/or suppliers or real estate investments in property not part of a company’s core operations). Divestiture of these types of "dormant" assets could generate additional value for stakeholders in a turnaround. Conclusion While the fundamental principles of valuation clearly apply to cross-border businesses and assets, it is important to note that these are some potential minefields that need to be dealt with, as illustrated by the experiences and solutions to Singer’s cross-border valuation challenges. It is critical in these types of situations to involve individuals with first-hand knowledge of these countries and expertise in properly assessing these risks. Skilled local expertise is very important in making informed valuation decisions because no amount of financial analysis can substitute for good judgment in this process. |
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