Restructuring

Bankruptcy courts typically rely on three valuation methods to determine a debtor’s enterprise value: comparable company analysis, precedent transaction analysis, and discounted cash flow analysis. As previously reported, the United States Bankruptcy Court for the Southern District of New York recently concluded that the DCF method was inappropriate for the valuation of dry bulk shipping companies because rate volatility obscured future cash flows. In re Genco Shipping & Trading Limited, Case No. 14-11108 (Bankr. S.D.N.Y. July 2, 2014). In the same decision, the bankruptcy court accorded substantial weight to a fourth, asset-based method: Net Asset Valuation. As with its holding with respect to the DCF method, the bankruptcy court’s decision to consider the NAV method could easily serve as precedent for the valuation of companies in other segments of the shipping industry, as well other industries that experience significant volatility in rates.

Background and Facts
Salient facts regarding Genco and the significant events in its bankruptcy case can be found in our earlier post.
To recap, Genco had approximately $1.48 billion in claims to be paid in full before equity holders would recover anything under the absolute priority rule. Genco submitted a prepackaged plan of reorganization, which was premised on an enterprise valuation between $1.36 billion and $1.44 billion. Genco’s secured lenders and holders of unsecured convertible notes unanimously approved the plan, but the equity committee objected to confirmation. The equity committee argued, among other things, that the debtors’ enterprise value was actually between $1.54 billion and $1.91 billion.
Whereas the debtors’ valuation relied entirely on the NAV analysis, the equity committee’s valuation was the weighted average of its DCF, comparable company, precedent transaction, and NAV analyses. To determine whether Genco’s enterprise value exceeded $1.48 billion, the bankruptcy court examined the testimony presented by both sides with respect to each of the four valuation methodologies. In the end, the bankruptcy court found that Genco’s enterprise value did not exceed $1.48 billion, and, therefore, the debtors’ plan did not give creditors a recovery greater than 100% of their claims and could be confirmed.
Debtors’ Net Asset Value Analysis
The bankruptcy court described the NAV method as the process of adding together the value of a company’s assets. Here the bulk of the asset value was in the debtors’ vessels, but they had other assets as well, such as equity stakes in other companies, service contracts, and cash on hand. To establish vessel values, the debtors turned to a variety of sources, including vessel appraisals from Marsoft and two unidentified shipbrokers, as well as VesselsValue, a recognized source of vessel value data. At trial, the debtors’ expert on vessel valuation was from Maritime Strategies International, and he used three approaches in his overall assessment.
The first approach was “econometric modeling,” in which the expert valued vessels “on the basis of their earning power, which changes depending on market fundamentals.” The second approach was a “time series” analysis, in which the expert derived vessel values after considering benchmarks, such as price, earnings, and operating costs, for the applicable classes of dry bulk vessels as “measured at successive points in time to extract characteristics of the data.” The third approach was a “last done” analysis, in which the expert considered recent sales and “market intelligence” on comparable vessels and made adjustments for the particular vessels in question. As part of his assessment, the debtors’ expert made adjustments to vessel values for the length of time before special and immediate surveys and based on engine make and model, the country and shipyard in which the vessel was built, vessel design and/or configuration, and a vessel’s desirability relative to similarly classed vessels. The debtors’ expert concluded that the aggregate “charter free market value” for Genco’s fleet was $1.21 billion.
On top of that, the debtors’ financial adviser then added the following:

• $40 million for net working capital,
• $98 million for equity stakes in other companies,
• $40 million for service contracts, and
• $4 million for other fixed assets.

In the end, the debtors’ NAV analysis produced an enterprise value between $1.36 billion and $1.44 billion, leaving equity holders out of the money.
Bankruptcy Court Adopts Net Asset Value Methodology for Dry Bulk Shippers
The equity committee did not challenge the substance of the debtors’ NAV analysis. Rather, it argued that the debtors’ asset-based methodology undervalued Genco as a going concern because it did not “fully account for all the tangible and intangible value of Genco’s corporate franchise, experienced management team, and future cash flows, which are the hallmarks of true going-concern enterprise valuation derived from traditional methodologies ….”
The bankruptcy court agreed that the NAV method should not be the “exclusive basis” for establishing the Genco’s enterprise value. It disagreed, however, with the equity committee’s “dismissive attitude” toward the NAV method (only 15% of its weighted average) and concluded that NAV was not only an appropriate method under the circumstances but also deserved “substantial weight” due the nature of dry bulk shipping. Specifically, the bankruptcy court cited the testimony of the debtors’ financial adviser and the treatise Maritime Economics to find that the dry bulk market “is competitive, highly fragmented, and has low barriers to entry” and resembles the perfect competition model developed in classical economics. Because shipping “companies keep investing until marginal cost equals price and in the long term marginal cost is the cost of capital,” the bankruptcy court concluded that the asset-based NAV method was “highly probative.”
The bankruptcy court further observed that the handful of comparable transactions identified by the parties corroborated the bankruptcy court’s conclusion because the indicative values in those transactions were “at or very near NAV.”
Lessons Learned
The bankruptcy court’s decision to accord substantial weight to the NAV method is particularly interesting in light of its decision to reject the DCF method because both methods rely on projections of future cash flows. The DCF method projected the future cash flows from operation of the debtors’ vessels and discounted those amounts to obtain a present value. The NAV method added together market values for the debtors’ vessels, which values are a function of expected future cash flows from operation of each vessel. Indeed, each of the three NAV “approaches” utilized by the debtors’ expert on vessel values considered the earning power of the debtors’ vessels.
The bankruptcy court appears to address the discrepancy by adopting the debtors’ explanation that the NAV method is “based on independent appraisals that incorporate an impartial assessment of the broadest, most concrete consensus regarding future earnings.” Yet, it does not explain how the “concrete consensus regarding future earnings” for the NAV analysis affected its determination that “[n]o accurate projections exist in this case” for the DCF analysis and its conclusion that the “volatility of the [dry bulk] industry is a sufficient basis by itself to reject a DCF analysis.” If rate volatility truly undermined the ability to project future earnings, vessel values based on market consensus regarding future earnings should also be inaccurate.
The bankruptcy court’s decision is also significant because it may extend well beyond the original context. As with its rejection of the DCF method for dry bulk shippers, the bankruptcy court’s decision turns on particular features of the dry bulk shipping market that can be observed both in other shipping segments as well as other industries. Thus, the Genco decision may offer precedent, or at least instruction, on the use of asset-based valuation methods, which will guide parties that would benefit from the lower enterprise values those methods generally produce.