Page 78 - Bankruptcy and Reorganization Services

structuring risk is the uncertainty surrounding the right-hand side of the balance sheet during a restruc-
turing process. This is a risk that principally affects the relative value of the various classes of capital.

Operational restructuring risk is the risk that the operations of the business cannot be successfully reor-
ganized so that the company can operate profitably enough to service its debt. Operational restructuring
risk is the uncertainty surrounding the left-hand side of the balance sheet during a restructuring process.
This is a risk that principally affects the overall value of the business.

Clearly, there is an interaction between the two types of restructuring risk, and most companies in finan-
cial distress face a combination of the two. However, each type of risk affects value differently and
should be treated differently when estimating the appropriate risk premium.

Both healthy and distressed companies can be over levered. For an otherwise healthy but over-levered
company, restructuring risk is generally limited to financial restructuring risk. For most healthy compa-
nies, it is unlikely that the restructuring will result in a liquidation of the business. The restructuring risk
affects the relative values of the classes of debt and equity capital, but is not likely to significantly affect
the business enterprise value. For companies like this, the restructuring risk premium in the cost of equi-
ty will likely be small.

Alternatively, for a distressed and over-levered company, restructuring risk will include both financial
restructuring risk and operational restructuring risk. For these companies, there is a greater possibility
that the restructuring will result in a liquidation of the business. The operational restructuring risk affects
the business enterprise value. This in turn leads to an increase in financial restructuring risk, which af-
fects the value of each of the capital classes. The essence of operational restructuring risk, however, is
rooted in the company-specific risk factors noted earlier. Accordingly, the restructuring risk premium
for unprofitable companies should be based on the collective impact of the company-specific risk factors
identified by the analyst.

Industry Risk (Build-up Approach Only). When using the build-up approach, it is advisable to include a
risk premium to reflect the subject company’s exposure to general risks that are specific to the industry
in which it operates. Industry risk can be a significant component of beta risk that is not captured using a
build-up approach. An industry risk premium essentially recognizes the fact that some industries are sys-
tematically more or less affected by macroeconomic conditions and events.

The estimation of the amount of the premium or discount needed to compensate for the various types of
company-specific risks requires analysis of the magnitude of the effect that these risks can have on the
subject business. Some of these risk factors, such as size risk and industry risk, have been empirically
measured by researchers and the adjustments can be readily obtained from proprietary services. The ma-
jority of company-specific risk factor adjustments must be estimated by the valuation analyst. Although
it will always be necessary to use professional judgment to estimate the appropriate risk premiums, the
valuation analyst should attempt to perform a quantitative analysis to support the selected premium ra-
ther than rely exclusively on professional judgment.

An important but often overlooked point is that although the company-specific risk factor is explicitly
included in the calculation of the discount rate, practitioners that employ company-specific risk factors
in the development of their discount rates should also consider such adjustments in the market approach
when calculating guideline company multiples and transaction multiples. If the subject company has
unique risk factors which are not reflected in the guideline companies through the multiples, a risk ad-
justment may be necessary.

76 © 2020 Association of International Certified Professional Accountants