Deferred tax assets: compounding value in distressed M&A

April 2015 | SPOTLIGHT | DISTRESSED M&A

Financier Worldwide Magazine

The current investment environment is made increasingly challenging by historically low interest rates, volatility and globalisation. These conditions have generally inflated stock markets. In turn, higher markets emphasise the value of corporate assets previously ignored. Examples include prospective asset sales, operational enhancements, contracts, as well as intangibles. Often overlooked by distressed investors, deferred tax assets are a source of value associated with bankruptcy.

By way of background, US corporate bankruptcies typically rely on a business valuation in support of a plan of reorganisation. The plan is the basis on which this legal proceeding is resolved and a company is allowed to emerge from Chapter 11. A frequent consideration in addition to the intrinsic value of an ongoing business enterprise is the incremental value of Net Operating Losses (NOLs). Accounted for as a deferred tax asset, NOLs are an inevitable by-product of a faltering business and accumulate prior to and during bankruptcy.

Disclosed in the footnotes to financial statements, depending on the opinion of a company’s accountant as to the timing of its use, the NOL may also be recorded as a deferred asset on the balance sheet. Regarded as more theoretical than practical, the conventional valuation of the NOL is calculated as the net present value of federal income taxes saved, discounting at an equity cost of capital, assuming the NOL can be utilised over 15 or 20 years. This term is based on provisions of the Internal Revenue Service (IRS) Code (Code) Section 382 (S. 382). Implicitly, this computation results in a conservative estimate of value as it assumes a high cost of equity capital for discounting and an extended period of years over which tax savings are realised.

Appreciating the utility of NOLs

There is a growing appreciation among investors for the potential value of this tax asset. This change in viewpoint reflects three developments in the market: the sheer volume of NOLs created following the economy’s collapse in 2008; the Federal Reserve Bank’s open market practice of quantitative easing (QE); and recent clarifying tax regulations. In the first instance, the amount of NOLs held by corporations following the economy’s tailspin has increased dramatically. While each business downturn brings a spate of corporate restructurings, secular growth in corporate indebtedness leading up to 2008 yielded record-setting defaulting debt which exceeded $330bn in 2009. With the attendant bankruptcies came record losses. The attention these NOLs have attracted was heightened by the American Recovery and Reinvestment Act of 2009, which took the unprecedented step of allowing the carryback of NOLs up to five years prior to incurrence. It is estimated that US public company holdings of NOLs individually exceeding $500m now total between $150bn and $200bn. These estimates exclude a plethora of smaller companies, as well as the substantial losses incurred by the government-sponsored mortgage companies, Freddie Mac and Fannie Mae, and participants in the US Treasury’s Troubled Asset Recovery Program (TARP).

Second, the Federal Reserve’s policy of QE explains the prevailing level of depressed interest rates and elevated equity valuations. As investors are driven to rely on lower hurdle rates, the value of NOLs is enhanced. In addition to the implied value lofty equity valuations place on NOLs, lower discount rates attribute higher value to fixed cash flows, including tax savings. As noted above, a higher value for deferred tax assets may also reflect a correction for a relatively high discount rate traditionally applied to NOLs.

Third, the preservation and use of NOLs in distressed and bankruptcy proceedings depends on strict adherence to IRS regulations. Specifically, S. 382 and related Code sections govern the permissible use of NOLs, limiting the percent of equity ownership changes allowed over time, the impact of rights offerings designed to raise fresh equity, as well as the rate at which NOLs can be utilised. In 2013, the IRS issued additional regulations providing greater clarity on these determinations, in particular the deemed impact of various equity raises on ownership tests. While complex, the detail and scope of these new regulations may be viewed as actually facilitating a company’s use of its NOLs with greater likelihood of acceptance by the IRS.

In addition to these factors, distressed investor interest in NOLs has also been piqued by the impressive performance over the past decade of several public corporations which have achieved very attractive long-term equity returns. These returns have come in part from the compounding of solid operating results by savings realised from embedded deferred tax assets. Case examples include Anixter International, Enstar Group and Covanta Holding.

Recent transactions in the market

There are several other recent transactions which substantiate an expectation of more distressed merger and acquisition transactions involving corporations with deferred tax assets. One example of a substantial embedded NOL supporting an investment is Leucadia National Corporation’s 2013 acquisition of the remaining public shares in the investment bank Jefferies Group. This stock-for-stock merger valued at $3.6bn is expected to benefit over time from the utility of Leucadia’s pre-existing $3.6bn NOL which followed from the earlier acquisition of WilTel Communications out of bankruptcy. WMI Holdings, Inc. (formerly, Washington Mutual, or WaMu) is another case in point. Exiting bankruptcy in 2012, in addition to a substantial mortgage reinsurance business, WaMu retained a nearly $6bn NOL. In late 2013, WaMu closed an equity investment and related commitment for acquisition financing from KKR & Co. The transaction is meant to fund future acquisitions of profitable enterprises. The market’s favourable reaction to this initiative is evident from a three-fold increase in WaMu’s equity market capitalisation post-announcement. Two other recapitalisation transactions over the past year involving corporations with material deferred tax assets include Signature Group (formerly, Fremont General) and Capmark Financial.

An important caveat

The utility of a tax asset always entails some risk of challenge by the IRS. For example, the right to claim a substantial NOL was attacked by the Department of Justice on behalf of the IRS in the bankruptcy proceeding in Delaware in 2012 of solar cell manufacturer, Solyndra LLC. At issue was the IRS’ contention that the sole purpose of Solyndra’s reorganisation under Chapter 11 was tax avoidance (an issue in this case addressed at Confirmation under Section 1129 of the US Bankruptcy Code). The bankruptcy court approved the plan of reorganisation over the government’s objections. Nevertheless, this serves as a pointed reminder of the critical importance in these undertakings of a bona fide business purpose underpinning the investment, separate from tax considerations.

Looking ahead

Given the size of the corporate NOL pool on which to draw in years to come, distressed investors should add deferred taxes to their standard investment screens, as well as a factor for consideration in investment strategy. Expect to see more distressed M&A transactions including NOLs as markets continue to strive for efficiencies. Affording respectability to efforts to capitalise on this incremental value is the adage from a venerable Judge of the Court of Appeals, the Honorable Learned Hand, “Over and again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible”.

Anders J. Maxwell is a partner and managing director at Peter J Solomon Company. He can be contacted on +1 (212) 508 1683 or by email: amaxwell@pjsc.com.

Anders J. Maxwell

Peter J Solomon Company