Valuations: A UK perspective

In this article, we discuss the heightened importance of valuations in UK restructuring scenarios and, in particular, how the valuation issues played out in the 2021 Virgin Active restructuring plan.

Background

Valuations have long been a sticky subject in many financial restructuring transactions—the value of the assets that are the subject of competing claims will frame the negotiations and form a base for the restructuring proposals.

Creditors (or shareholders) whose claims are "out of the money" (i.e. the value of the business is such that the creditor will have no recovery based on the relative creditor lien(s) and other priorities) can find themselves subject to a procedure (or the threat of a procedure) that, while saving the business as a going concern, sees valuable assets (and therefore, potential for future recoveries) moved out of their reach. Stakeholders often commission competing valuations with differing methodologies in the hope of obtaining the best possible outcome for themselves.

This is what happened in IMO Car Wash¹, a landmark 2009 case involving a substantial valuation dispute. In this case, the debtor group and the senior creditors sought to exclude the mezzanine creditors from a debt-for-equity swap on the basis that the going concern value of the business broke above the mezzanine debt (i.e. that the mezzanine creditors were out of the money). The debtors' valuation was based on various methodologies, including discounted cash flows and multiples in transactions involving the sale and purchase of similar businesses in the same sector as the group. This valuation was contested by the mezzanine creditors on the basis that it did not reflect the economic climate and the lack of relevant transactions in the sector from which to draw comparisons. The mezzanine creditors carried out their own analysis based on projected future cash flow in a number of simulations generated by a computer model to show the "intrinsic value" of the business and a potential return to the mezzanine creditors. The court found in favour of the "real world assumptions" of the debtors' valuation, noting that: a proper approach to valuation in a case such as this requires some real-world judgments as to what is likely to happen… rather than a range to which other ranges are applied in a series of random calculations to come up with some mechanistic probability calculation.

The restructuring plan's "relevant alternative" and valuations

In 2020, the UK introduced a new restructuring plan to its statutory restructuring procedures. The new restructuring plan (in Part 26A of the Companies Act 2006) is similar to a scheme of arrangement, but "super-charged" with the potential for a company to cram down dissenting creditors across classes and ignore "out of the money" creditors that do not have a genuine economic interest in the company.

The cross-class cram down is available where 75 percent (by value) of one class vote in favour of the plan, and no member of the dissenting class would be any worse off than they would be in the event of the "relevant alternative" (being whatever the court considers would be most likely to occur in relation to the company if the plan were not sanctioned). This test requires first an assessment of the relevant alternative, and then an assessment of the likely returns in that relevant alternative compared to the likely returns if the plan was sanctioned.

The importance of the valuation in this test (and therefore the potential for dispute) is clear. As noted by Snowden J in his judgment in the Virgin Active² case:

…the possibility of the Part 26A regime giving rise to valuation disputes was foreshadowed in [the Government's] response to the outcome of its consultation on "Insolvency and Corporate Governance" published on 26 August 2018: "Many respondents noted how contentious valuation can be…. The Government acknowledges that disputes over valuation may result in costs and delay to restructuring plans being confirmed or not. The responses received indicate that it is highly unlikely that any standard chosen would completely remove the potential for dispute given the importance of the valuation in determining who may be crammed down."

Virgin Active: Dissenting creditors are no "worse off" and key takeaways for valuations in future restructuring plans

In Virgin Active, the gym and leisure group proposed a restructuring plan to compromise its leasehold liabilities. This was the first restructuring plan to seek court approval to cram down dissenting landlords; prior to the introduction of the restructuring plan, the statutory procedure commonly used by companies to achieve such ends was a company voluntary arrangement. In the current case, the leases were split up into five classes based on profitability/value—those in classes A and B (the most valuable and those the group was keen to retain) being treated more favourably than those in classes C, D, and E (the less valuable). Amongst the landlords, only the class A landlords voted in favour of the plan. The dissenting landlords objected to their treatment at the sanction hearing.

The relevant alternative put forward by the group was an insolvency procedure (administration) in which the secured creditors would fund an accelerated sale process of certain valuable parts of the group. The group valuations were carried out on a going concern and debt-free basis, and assumed a willing buyer and a willing seller would be found for an orderly sale. The valuations did not account for circumstances which might have adversely affected the value achieved on a sale (such as the requirement for the sale to take place on an accelerated basis in an administration), and so a distressed discount was applied when considering the valuation required to see the dissenting landlords receive a return.

In a May 2021 decision, Snowden J provided a helpful framework which will be of use when considering valuation issues in this context going forward:

1. Market testing is not mandatory

The valuations provided by the group were desktop valuations carried out on a discounted cash flow basis and cross checked against other valuation methods and forecasts. The dissenting landlords argued that a market testing process should have been conducted to value the plan companies' assets. The court found there was "no absolute obligation" in legislation or otherwise, to conduct a market testing process as part of the process. Snowden J noted there is no evidence that market testing is "habitually" used (as argued by the landlords) and it was unclear how funding for such a process would have been obtained. Finally, it was noted that the outcome of any market testing would have had to be treated with "extreme caution", given it involved a gym and leisure business in an already depressed market when most of the sector was closed as a consequence of COVID. This gives companies considering a restructuring plan the comfort of knowing that there is no requirement to test the market before proposing the plan.

2. The sophisticated creditor

The dissenting landlords argued that the evidence before the court was not the best evidence it might have had if the plan companies had conducted the process differently, particularly given difficulties accessing information (some of which was delivered late). The court didn't agree and held that the dissenting landlords had been provided with sufficient information to analyse the proposal. Snowden J noted that the dissenting landlords were "sophisticated commercial parties" who had instructed "sophisticated advisers" and that all parties had been operating "to a compressed timetable in a matter of real urgency". The fact that only one formal valuation existed was because the dissenting landlords had failed to put forward their own. One could say this was the main reason the dissenting landlords failed—had they adduced their own valuation evidence showing a higher value, the outcome may have been different.

3. Unreliable valuation evidence

The dissenting landlords argued that there was uncertainty in the underlying valuation evidence put forward by the plan companies, specifically that the multiples and calculations were flawed. Again, the court was not sympathetic to these arguments, noting that valuations will inevitably produce a range of possible outcomes and it is for professional advisers to show what is most likely to occur under the circumstances from those outcomes. As above, dissenting creditors should think twice before going on the attack without strong alternative evidence in hand.

4. The court doesn't want lengthy disputes

Snowden J considered the above-mentioned government consultation and reminded parties that the restructuring plan and the process generally was aimed at protecting the rights of dissenting creditors by ensuring that they were "no worse off" than the relevant alternative. The existence of different valuation methodologies resulting in lengthy disputes should not undermine the fundamentals of a plan. The court expects companies to cooperate with their creditors in a timely fashion and provide adequate information with the aim of efficient resolution of "genuine valuation disputes".

5. "Out of the money," out of luck

As counsel for the dissenting landlords put it: "if you are not sitting at the table, that is because you are lunch". In the money creditors remain in a strong position to drive through a restructuring transaction with the debtor without significant (if any) input from out of the money creditors. The out of the money creditors (in this case, the dissenting landlords) carried little to no weight on the outcome of the plan—the court noting that it should be for those with an interest in the "restructuring surplus" to drive the procedure and decide on the allocation of value.

The relevant alternative isn't always an insolvency process

In another landmark case heard in June 2021, Re Hurricane Energy³, the High Court declined to sanction a debt for equity restructuring plan proposed by the company and supported by its bondholders that sought to cram down the existing shareholder class and dilute their holding to five percent. Unlike Virgin Active, the relevant alternative here was not an insolvency procedure, but continued trading. The court found that there was a realistic prospect that the company would be able to discharge its obligations to bondholders, thereby leaving assets with at least potential for exploitation, and this was sufficient to refute the contention that the shareholders would be no better off under the relevant alternative than under the plan.

Conclusion

The Virgin Active case has given practitioners clear and helpful guidance on the use of valuations in restructuring plans. It is hoped that this guidance will assist parties in agreeing their financial restructuring transactions without lengthy (and costly) valuation disputes. However, where a dispute is looming, sound alternative valuation evidence is vital to protecting the position of dissenting creditors.