The Future of Solvency and Adequate Capitalization Analysis

posted in: Valuation | 0

By Michael Simkovic, Seton Hall University School of Law

Valuation, solvency, and adequate capitalization analyses play a crucial role in corporate reorganization. Courts and bankruptcy professionals have often complained about the expense, delay, subjectivity, and unpredictability inherent in traditional approaches to valuation.

However, newer methods based on market prices for equity, debt, or options and derivatives are supplementing, and in some cases supplanting more established approaches. One proposal is that instead of looking to bond or equity prices, courts should look to credit spreads between corporate and treasury bonds. Because investors could eliminate almost all credit risk by selling a corporate bond and purchasing a treasury bond, the difference in yield between a corporate bond and a treasury bond must compensate investors for the additional risks of non-payment of corporate bonds.

Credit spreads offer a clear indicator of market actors’ expectations about the likelihood of default and the likely losses given default. With a single assumption about recovery rates—which can be grounded in historic data or sometimes backed out from contemporaneous market data—one can reconstruct a daily market estimate of a debtors’ probability of default.

Credit-spread based approaches are faster, less expensive, and more objective than current approaches. An example is provided below using data for Caesar’s Entertainment Operating Company:

 

Figure 1. Caesars risk-neutral market-implied probability of default from CDS and bond spreads (preliminary analysis).

 

The traditional financial analysis performed by the Examiner in Caesars required months of work and only looked at a few specific dates. The preliminary market-based analysis above was completed by a law professor in a few days, and indicates capital adequacy on a daily basis.

If market-based approaches to solvency analysis could be used with confidence in many large corporate bankruptcy cases, the collective savings to debtors’ estates over a decade could easily be in the tens of millions of dollars.