3 Fairness & Solvency Opinion Themes In The Context Of Latest Oil & Gas Bankruptcy Cycle
As oil and gas bankruptcies continue to mount, the importance of fairness and solvency opinions shouldn’t be overlooked.
By James Hanson
We’ve been keeping busy, but unfortunately for the oil and gas sector, it has been especially busy in our Restructuring group. As we help clients navigate these difficult times, we’ve been noticing several common themes as they relate to fairness and solvency opinions, which can provide lessons learned for companies and sponsors negotiating and executing regular-way transactions (outside of a restructuring scenario). Listed below are three high-level observations of those trends:
1. Solvency Opinions
At the beginning of any restructuring assignment, as an advisor to either the debtor or creditor, potential fraudulent transfer claims on historical transactions, transfers and even management contracts are evaluated. In this cycle, as with previous ones, unfortunately, we see that solvency opinions are the exception rather than the norm.
"One of the things solvency opinion providers like us look at is: what's the company’s ability to withstand cyclical downturns?"
As a director or manager, its typically easier to defend decisions based on review of independent third-party analysis. Even the act of hiring an advisor is evidence of taking fiduciary responsibility seriously. We’ve also been interested to see that many companies, and even sponsors, aren’t even aware of solvency opinions.
We’ve also been observing that even when solvency opinions are commissioned, they’re for big marquee sales of divisions, spin-offs and dividend recaps. And while, certainly, those transactions benefit the most from solvency opinions, many smaller transfers, sales, dividends and even management contracts can benefit from an opinion.
People often don’t consider solvency opinions because they know the cost of opinions on marquee deals can be high and assume they’ll be too expensive. Solvency (and fairness) opinions are priced depending on the specific circumstances of a transaction and are often much less expensive than expected.
Find out how we added value by providing a fairness opinion for a private equity portfolio company merger.
2. Sensitivity Analysis
We’ve been seeing this over and over in our restructuring assignments. When reviewing historical transactions for potential fraudulent transfer claims, either in the context of defending or attacking, the inflection point of whether the company was left solvent in a market like this hinge on the “unreasonably small capital” test.
One of the things solvency opinion providers like us look at is: what's the company’s ability to withstand cyclical downturns? To evaluate this, we look at sensitivity (downside) analysis. The problem with this is that, after the fact, in a restructuring or bankruptcy scenario, often the down-side scenarios look too light-handed. This is a classic hindsight bias.
What we’re seeing is that, even in cases where the company didn’t get a solvency opinion, there was a downside scenario run. This is a great fact pattern but, in a challenge, the issue becomes defending the assumptions. As we’ve seen in El Paso and other cases, the courts dislike the explanation, “This was our standard procedure” or “This is what we always did” or, the worst, “It was our professional judgement.”
The courts aren’t necessarily looking for Boards, management teams and/or advisors to be clairvoyant, but they are looking to see that sound business judgement was employed. A 20% hit to commodity prices is hard to defend in a vacuum when commodity prices decline by half.
However, assumptions are much more defensible if the advisor provided context with analysis about things like:
- Are current prices high or low in a historical context?
- Where are we in the cycle?
- How long have previous cycles lasted?
- What’s the supply and demand context?
- What’s the regional and global economic outlook and other similar factors?
If a decision maker or advisor evaluated these kinds of contextual items and used them to derive a specific downside scenario, even in hindsight, the analysis may not end up being right, but it will be defensible.
3. Down-Round Financings
This isn’t something that we’re seeing necessarily in our Restructuring practice, but it’s nonetheless a result of the ongoing oil and gas downturn. In this environment, many private companies, including sponsor-backed, are looking to add equity capital, either to take advantage of merger and acquisition (“M&A”) opportunities or, sometimes, just defensively to deleverage.
Given the industry downturn, equity capital raises would most likely be done at valuations lower than the previous round of equity. In an opposite dynamic as noted above, if and when the market does recover, a company is potentially open to claims from the previous equity holders that the raise was priced too low to benefit the new holders.
Conversely, if the industry continues to decline, the opposite claim by the new holders could be made. Many times, Boards and management teams commission a two-sided fairness opinion on the valuation of the raise to protect against such claims.
About the Author:
James Hanson is a Managing Director with Opportune Partners LLC, an investment banking and financial advisory affiliate of Opportune LLP, a leading global energy business advisory firm. James has nearly 30 years of commercial and investment banking, capital raising and M&A transaction advisory experience. Prior to joining Opportune, James served as Managing Director, Energy Transaction Opinions for all energy subsectors, at Duff & Phelps where he advised and executed 70 engagements representing over $50 billion of transaction value. These transactions included fairness opinions, solvency opinions, debt opinions and reasonably equivalent value opinions. James began his career specializing in energy investment banking at Salomon Brothers, Bear Stearns and Barclays Capital where he advised a wide variety of large cap and mid cap energy companies in M&A and public capital markets transactions, raising over $25 billion for his clients. James holds an MBA in Finance from The Wharton School, University of Pennsylvania, and a BS in Finance from the University of Illinois. He received the chartered financial analyst (CFA) designation and is a FINRA Series 7, Series 24 and Series 63 registered representative.