Shutting up shop in time, over time – the bankruptcy evaluation challenge
Dissolving a business is no laughing matter, especially when the issue of shareholder equity is part of the equation. In order to maximise the remaining assets within the business, declaring bankruptcy at the right moment and allowing the time it will take to cease business activities altogether can have a major impact on the smoothness of the operation.
Simply looking at the current state of the market and assuming a business can be closed overnight is no longer a satisfactory basis on which to plan so important a decision.
One of the key skills of the corporate financial analyst is to establish as accurately as possible the health of a company, in bad times and good, and to assess its chances of continued survival in relation to the state of the market. However, this process should also involve a degree of “digging into the past” in order to establish how a company has been performing over a sustained period of time before taking the onerous decision of declaring bankruptcy and preparing to disinvest. Until now, it is surprising the extent to which the latter process has been overlooked. By analysing the examples of insurance companies and banks and the volatile nature of both their income and charges, a broader and ultimately more cautious approach to preparing the closure of a business makes all the more sense.
Setting a threshold
Insurance companies and banks and the services they offer are, by nature, exposed regularly to the vagaries of the market. In the former case, insurers receive premiums from their customers who, in the event of a successful claim, must be compensated. Insurers will often invest in temporary premiums in order to try to generate extra income but these are especially volatile due to the impact that market fluctuations can have on their value. Likewise, banks are in a business which, by definition, sees their return on investment and the cost of funding very much at the mercy of the market. However, when any such organisations encounter financial difficulties and the prospect of bankruptcy, studying the current state of affairs is not enough. A threshold has to be planned and costed in advance, based on previous operations as well as the present day.
Establishing an evaluation framework
In such a scenario, the best financial analysts will truly earn their keep by taking a 360 degree view of the business in question that goes far beyond purely establishing its current health. Firstly the probability of bankruptcy needs to be established, before dealing with the issue of timing in the event of disinvestment being the “best” solution. A default threshold proportional to charges needs to be set in order to establish the ideal timing for bankruptcy declaration and also in order to maximise any shareholder equities that may be tied up in the business. In addition, these equities need to be evaluated in relation to expected value operators that take into account not only the quick-fire bankruptcy scenario. Consideration must also be given to a more protracted bankruptcy process, during which the market may continue to have an impact on the performance of the business during its final weeks and months.
Looking into the past to prepare the future
The financial markets are incomplete and volatile entities – negative and positive jumps can occur at any time and so to try to apply a risk-free measure in order to evaluate the health of a company would be to ignore the characteristics of the market that the company is impacted by. Where many analysts have gone wrong until now is to focus solely on the current financial climate. In order to take the decision to dissolve a business or not requires delving into the previous share prices and accounting information of a company rather than just testing the present temperature. Companies such as banks or insurers where the traditional portfolio split between secure state or corporate bonds and riskier stocks or assets averages 65/35 are especially in need of this combined retroactive-prospective analytical approach.
Saving the furniture
A recent case study of the insurance giants AXA and Generali adopted precisely this approach, comprising the application of a number of complex mathematical formulae and recourse to expected present value operators in order to establish not only the probability of declaring bankruptcy but also the lag time between declaration and actual cessation of activity.
It emerged that companies and those performing the initial analysis should expect an average of six months between the two. This is higher than the typical forecasts of credit analysts in recent times and underlines the importance of getting the timing right and, above all, allowing for the potential jumps up or down in value of the company before they definitively shut up shop. In these troubled economic times, caution should be taken more than ever. Disinvesting a business is a thankless task but, in order to save the furniture, it is in the interests of all stakeholders to get the house in order. Timing is therefore key, through a subtle blend of forward-planning and historical analysis of the company’s performance.
This article draws inspiration from the paper Evaluation and default time for companies with uncertain cash flows, written by Donatien Hainaut and published in Insurance: Mathematics and Economics 61 (2014).
Donatien Hainaut is an associate professor of Finance and Accounting at Rennes School of Business, France. His research interests include Quantitative Finance, Risk Management, Pricing of Financial and Insurance Derivatives, and Asset Liability Management