Business Valuation In Chapter 11

Pershing Square's much anticipated second quarter letter finally leaked onto Dealbreaker recently, and it was interesting getting some perspective from Bill Ackman on the fund's performance, successes and candid admission of mistakes and missed opportunities during that period.

I won't reiterate the various comments made in the section around General Growth Properties beyond two quotes. Firstly the final comment:

"..GGP is a highly leveraged company and there continues to be substantial uncertainty about the potential outcomes for GGP security holders." Pershing Square Q2 2009 Shareholder Letter

It was good to see an appropriately cautionary note raised around General Growth Properties share valuation, and to make sure that those currently looking at recent returns remember that this remains a risky investment. However that is also why in theory despite large rises to date, it still remains potentially excellent value.

The headline $40/share figure that everybody has latched onto comes from Ackman making a very high level statement that the REIT most comparable to GGP is Simon Properties. That is definitely true in terms of size, portfolio quality and overall market position, although obviously not in terms of risk. Ackman uses this purely to demonstrate that assuming GGP risk reduces as Chapter 11 negotiations proceed, and clarity is gained relating to shareholder dilution, then we should look at General Growth eventually trading at an equivalent cap rate.

That gives a $40/share figure based on the current portfolio and capital structure, but crucially assumes a best case scenario of zero dilution for shareholders. It merely highlights potential, and is not intended to be some sort of predication of future value. Anybody reading the report and assuming otherwise would be wise to consider further this comment:

"The balance of GGP's value should inure to the benefit of the company's shareholders. As a result, the company's valuation will likely play an important role in determining recoveries for shareholders." Pershing Square Q2 2009 Shareholder Letter

Determining Value In Chapter 11
So what are the crucial factors that will determine GGP company valuation within Chapter 11, and how is this process going to work?

This e-zine article on determining value within Chapter 11 does make a number of interesting points about factors that could impact GGP. To my mind the key factors are as follows:

1. Valuation Experts
There will be various external specialists within the commercial real estate sector able to provide an accurate market assessment of the current asset valuations of General Growth Properties. Representatives will be put forwards behalf of the creditors and debtor (GGP).

2. Valuation Methodologies
Methodologies will need to be applied, and will be scrutinised by the Court in detail to ensure impartiality and accuracy. These typically consider a wide number of factors: potential competitors available to purchase assets (i.e. market demand), industry trends (i.e. falling property values, occupancy rates and profitability) and general valuations of comparable rivals - this goes back to SPG.

3. Assumptions
Any disagreements will be submitted to the Court for resolution. One example in the article is a case where valuation cited by the creditors applied a 'bankruptcy taint' impairment if the company remained whole - presumably due to reputational damage. In GGP's case I do not think this will apply due to market conditions and the business continue to operate meantime.

4. Asset Liquidation vs Going Concern
Here valuation experts will give an assessment on which scenario maximises value, and will account for extenuating factors such as exceptional market conditions. It may be within this that some sell off of assets is agreed and included in the plan to reduce leverage.

"The premise of value utilized in the valuation process assumes either a 'going concern' or 'liquidation' of the subject. The Bankruptcy court utilizes the outcomes of these different assumptions-based approaches to make its determination."

Company specific risk will be the main consideration here, and in the case of GGP, there is a particularly strong case for its viability as a going concern: i) positive cashflow generation, ii) ability to raise DIP financing in a distressed market, and iii) voluntary servicing of creditors despite an automatic stay.

The coming months will see some interesting discussions around the above points, and it will be this determination of value and willingness to extend maturities that will ultimately decide how much or little equity value is retained by common shareholders.