‘Cherry-Picking’ Valuation Factors Leads to Discredited DCF

By Sylvia Golden, JD, Legal Editor, Business Valuation Update

In re Bachrach Clothing, Inc., 2012 Bankr. LEXIS 4807 (Oct. 10, 2012)

The owners of a family-run men’s apparel business agreed to sell their stock to a private equity firm for $4 million in cash and $4 million in a subordinated note. The PE firm structured the sale as a leveraged buyout (LBO), transferring the acquired stock to an affiliated entity and then immediately replacing the target’s board of directors with its own executives.

The PE firm then appointed a new CEO, who marked down the company’s inventory by $7 million, or more than 285% of the budgeted amount. Overall, the changes eroded $3 million in working capital, thereby reducing the company’s borrowing base from $4.3 million to $1.3 million. At the same time, the company continued to pay the PE firm $400,000 in management fees plus the costs of the purchase, including attorneys’ fees of over $800,000, which eventually amounted to over $3 million in extraordinary expenses.

To address the company’s liquidity crunch, the PE firm announced it would make an additional $5 million equity investment in early 2006. But, after a few months, the PE firm instead withdrew its funding, forcing the company into Chapter 11—and starting this lawsuit against the former owners to recover the purchase price as a fraudulent conveyance.

Even though the parties’ experts relied on essentially the same data and analysis, the “striking” disparity among their conclusions “lends credibility to the concept that the DCF method is subject to manipulation,” the court said, citing In re Iridium Operating LLC, 373 B.R. 283 (Bank. S.D. 2007) (available at BVLaw). Indeed, the court reiterated Iridium’s warning that:

The DCF methodology has been subject to criticism for its flexibility; a skilled practitioner can come up with just about any value he wants. For this reason, it is important to validate conclusions reached using this methodology by comparing the results obtained when other accepted approaches to valuation are used.

In this case, the court found that “each expert generally selected parameters that pushed his valuation in the direction he wanted to go.”

Some examples of differences that appeared to the court to lack neutrality included:

• All the experts considered a balance sheet approach, but the debtor’s expert ultimately rejected the company’s audited, consolidated balance sheet, prepared in connection with the sale, because he believed its reliance on historic book value did not reflect fair market values. By contrast, the owner’s experts used the audited book value as a starting point and then adjusted it downward by nearly $4.2 million to reflect “known market conditions.” Under this analysis, they concluded the company was worth $9 million at the time of sale.


• The debtor’s DCF analysis determined the company was worth $1.1 million, but after factoring in the $400,000 management fee to the PE firm, the value was negative $293,000. Under their DCF analysis, the defendants’ experts believed the company was worth just over $6 million. The experts’ disagreement largely came down to how each calculated the weighted average cost of capital (WACC) under a CAPM approach, with the debtor’s expert concluding a rate of 19.5% compared to the defendants’ experts, who derived a 12.3% rate. This disparity stemmed from the experts’ treatment of the following four inputs:


• Debt-to-equity ratio. The debtor’s expert chose not to consider the company’s actual capital structure, believing this better reflected the view of a hypothetical purchaser. Instead, he used industry standards as well as the debt structure of comparable companies to establish debt-to-equity ratios for his WACC. However, the defendants’ experts “insisted” that it was a mistake to ignore the company’s actual capital structure, particularly when its actual borrowing capacity at the time of sale made it a particularly valuable prospect and its debt-to-equity ratio was well below that of comparable companies.


• Equity risk premium (ERP). By using Ibbotson’s longest data set (going all the way back to 1926), the debtor’s expert derived an ERP of 7.2%. By contrast, the defendants’ experts believed a shorter time period, going back only 50 years, more appropriately accounted for globalization and its effect on market trends, arriving at a 5.6% ERP. (Notably, in their determination of ERP, all of the experts cited Aswath Damodaran’s Investment Valuation (John Wiley & Sons, 2012), in which he recommends an historical ERP of no more than 5.5%.)


• Size premium. Once again, the experts used Ibbotson’s data to derive their respective size premiums. Although the company’s market capitalization fit into three size categories—the micro-cap category (deciles 9 and 10) as well as 10 and 10b—the debtor’s expert selected the smallest (10b) because the company was smaller than most in that subdecile and Ibbotson indicated the 10b results were “statistically reliable.” This led to a 9.8% size premium. The defendants’ experts believed the micro-cap category was more statistically reliable and a better fit for the company, particularly since Ibbotson found that smaller apparel and accessory stores performed better than their larger-store counterparts. They also cited Damodaran’s recommendation of 4% for small cap stocks, ultimately arriving at 4.2% size premium for the subject company.


• Terminal value. Using the Gordon growth model, the debtor’s expert applied a 3% growth rate to his cash flow projections to reach his terminal value. The defendants’ experts, on the other hand, used an exit multiple approach, applying a 6.5 multiple to projected EBITDA. They derived the 6.5 multiple from comparable companies as well as comparable transactions, and believed the multiple was “conservative” because it fell within the lower quartile of comparable companies and none of the comparable sales involved a lower multiple. (The debtor’s expert criticized the “hybrid” exit multiple approach, once again citing Damodaran’s treatise and his warning that the use of multiples to calculate terminal value in a DCF results in a “dangerous mix of relative and discounted cash flow valuation.” He also used the experts’ exit multiple to “back solve” for an implied growth rate of 6.9%, which was more than twice the current economic growth rate.)


• Overall, the defendants’ experts provided “better reasoned” explanations for their DCF inputs and their $6 million enterprise value was “more aligned with real world events or contemporaneous market data,” the court held. The court found “no facts or real world evidence” to support the assertion of insolvency. The company had no long-term debt, was current on payables, and held substantial cash in excess of working capital. In fact, the court found, the PE firm and its hand-picked CEO “created [the company’s] liquidity crisis,” the court said, and the investors' "refusal to provide further capital led to this bankruptcy."

In particular:

• The court dismissed the negative valuation by the debtor’s expert, noting that his inclusion of management fees that were unique to the sale was inconsistent with his valuing the sale from the perspective of a hypothetical buyer.


• The debtor’s expert should have used the company’s actual capital structure rather than an industry standard. “Regardless of who purchases a business, a company with actual leverage of 90% has to be worth less than a company with no debt,” the court stated.


• In determining the equity risk premium, both experts should have used the geometric mean instead of the arithmetic mean, which the court found (apparently after its own reading) Damodaran used to reach his historic ERP of 5.5%. Further, Damodaran indicates the “arithmetic average return is likely to overstate the premium” and that if “forced to choose” an ERP over the entire historic range of Ibbotson data, he would “go with 4.31%, the geometric average risk premium for stocks over Treasury bonds,” but his preferred approach was “market neutral” and less than 3%.


• As a result, both experts overstated the ERP, the court found. However, the 5.6% used by the defendants’ experts was closer to Damodaran’s estimates, while the 7.2% ERP by the debtor’s expert was more than double the professor’s preferred approach “and just not realistic.”


• Regarding the size premium, the debtor’s expert “did not pay particular attention to Ibbotson’s point that the 10b decile might be less reliable,” the court noted. Had he used the micro-cap category, his size premium would have been 4.0%—or less than half his selected rate of 9.8%. The defendants’ experts, on the other hand, appropriately factored in industry-specific phenomena to “inform” their decision about the size premium. Their selection of 4.2% also coincided with Damodaran’s recommended 4%.


• Similarly, their use of an exit multiple or “hybrid” approach in calculating a terminal value found support in Damodaran’s treatise; their use of comparable company data as well as economic growth rates went beyond merely “consulting a book,” the court said. “Again, real world information about the performance and sales of [comparable] companies informed [their] valuation of the terminal period,” while the debtor’s expert continued to “shuffle numbers in and out of formulas to get where he needed to go.”


• The court also found that the debtor’s expert “exaggerated” the company’s liabilities, which he should have discounted due to the PE firm’s co-obligation on the various loans. His “more glaring error,” however, was to match any contingent liabilities against contingent assets, the court said, citing Paloian v. LaSalle Bank, N.A., 619 F.3d 688 (7th Cir. 2011) (available at BVLaw).