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Relying on solvency opinions

When reviewing leveraged transactions, a company board will often seek third-party solvency opinions. Each and every solvency opinion is subject to a unique analysis since the solvency opinion is – by definition – only applicable to one, single, unique business entity. As such, there are no “hard and fast” rules that apply to completing a solvency analysis. It is critical for a board to seek an experienced, third-party provider who can illustrate its solvency analysis capabilities and defend their opinion in the event of future litigation.

General considerations

Company boards may seek an outside solvency opinion for:

  • Leveraged buyout (LBO) deals where leverage is significant
  • Public company share repurchase programs
  • Dividend recapitalization transactions

Boards should consider the following questions when evaluating a solvency opinion provider:

  • Does the firm regularly provide solvency opinions?
  • How many opinions have they previously provided?
  • How long has the firm providing the opinion been in business?
  • Has the firm successfully defended its opinions in the past?
  • Will the firm advise you against consummating a transaction if it is not appropriate?
  • Will the opinion assist in defending against potential liability claims when performing fiduciary obligation associated with transaction?

Additional factors

A board should keep in mind these additional factors that may affect a solvency opinion analysis and the recommended outcome.

Economic and industry risk factors: It’s important to understand the company’s business sensitivities to the general economic cycle and current industry trends. A key question is whether the industry is expected to grow or contract over the forecast period. If trends are positive and market growth is expected, this provides a favorable context for a leveraged transaction.

Company-specific factors: A board should be aware if long-term trends and current trends are positive or negative, as well as their principal drivers, and if recent growth is expected to be permanent or temporary. The board should also review if the company has successfully reduced debt or delevered over time, and if the proposed increase in leverage leads to a downgrade in credit ratings.

Valuation considerations: An adequate equity cushion is necessary if they pursue the leveraged transaction. Additionally, solvency opinion providers will often compare the overall multiple implied by the solvency valuation to the original entry multiple paid. If multiples are materially different,especially if the implied solvency multiple is higher, it is useful to understand why; an increase may be due to an improvement in trading multiples for comparable public companies or industry M&A multiples, or both, or due to other acquisitions.

Cash flow testing: The cash flow coverage model verifies if the company will have adequate cash flow under the new debt load to operate and make its principal and interest payments. Sensitivity analysis on financial projections show downside scenarios to determine if the company can still make payments.

Each company has weaknesses and vulnerabilities, and boards need to ensure the solvency opinion provider they select has fully accounted for them in developing an opinion. Boards must identify the operational and financial risks of the subject company and evaluate those factors to adequately develop an opinion.

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Bryan Browning, CFA, ASA, is a managing director with Valuation Research Corporation. Qualified in both real estate valuations and value-related financial analysis, he devotes most of his time to valuations of intellectual property, capital stock and business enterprises. He also develops opinions concerning solvency, fairness and capital adequacy.

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