ALLOCATION OF RISK IN A ALLOCATION OF RISK IN A BUSINESS RESTRUCTURINGBUSINESS RESTRUCTURING

Rutger Hafkenscheid – Taxand NetherlandsRutger Hafkenscheid – Taxand Netherlands

(Re)allocation of risk(Re)allocation of risk

TPG 9.10: Risks are of critical importance in TPG 9.10: Risks are of critical importance in the context of business restructurings. (….) the context of business restructurings. (….) In the open market, the assumption of In the open market, the assumption of increased risk would also be compensated by increased risk would also be compensated by an increase in the expected return, although an increase in the expected return, although the actual return may or may not increase the actual return may or may not increase depending on the degree to which the risks depending on the degree to which the risks are actually realised.are actually realised.

Notion: there is (or should be) an arm’s Notion: there is (or should be) an arm’s length relation between risk and returnlength relation between risk and return

RiskRisk

Inherent to risk is that one event may Inherent to risk is that one event may have two or more scenarios and thus have two or more scenarios and thus two or more outcomestwo or more outcomes

Economic theory uses three Economic theory uses three measurements to evaluate riskmeasurements to evaluate risk– Expected valueExpected value– VarianceVariance– WACCWACC

Expected valueExpected value

Definition: probability weighted Definition: probability weighted average of all possible outcomes.average of all possible outcomes.

ExampleExample

Allows to compare two investments with Allows to compare two investments with different returns and risk profiles.different returns and risk profiles.

VarianceVariance

Definition: distance between expected Definition: distance between expected value and possible outcomesvalue and possible outcomes

ExampleExample– Investment A: variance from $46,000 is -Investment A: variance from $46,000 is -$56,000 and +$14,000$56,000 and +$14,000

– Investment B: variance from $41,250 is -Investment B: variance from $41,250 is -$46,250 and +$8,750.$46,250 and +$8,750.

Allows to compare the relative risk Allows to compare the relative risk profiles of two investmentsprofiles of two investments

Often expressed in standard deviationOften expressed in standard deviation

Risk-return relationRisk-return relation

Expected returnExpected return

VarianceVariance

Risk-return trade-offsRisk-return trade-offs

Risk premiumRisk premium

Profit potential given up

Profit potential given up

Loss potential hedged

Loss potential hedged

Weighted average cost of capital Weighted average cost of capital (WACC)(WACC)

WACCWACC

Average cost of equity

Average cost of equity

Average cost of debt

Average cost of debt

Capital structure (D/E Ratio)

Capital structure (D/E Ratio)

Cost of equityCost of equity

Average gross cost of debt

Average gross cost of debt

Tax shieldTax shield

Risk free rate(3-4%)

Risk free rate(3-4%)

Market risk premium(4-5%)

Market risk premium(4-5%)

Industry beta

(0.68-2.4)

Industry beta

(0.68-2.4)

Allows to compare the values of two investments Allows to compare the values of two investments with a different risk profile by discounting their with a different risk profile by discounting their cashflows at a risk adjusted discount ratecashflows at a risk adjusted discount rate

ExampleExample

Risk-return trade-offsRisk-return trade-offs

WACC 12%WACC 12%

WACC 7%WACC 7%

Risk-return trade-offsRisk-return trade-offs(TPG 9.10): In the open market, the assumption of increased risk would also be compensated by an increase in the expected return, although the actual return may or may not increase depending on the degree to which the risks are actually realised.

(TPG 9.10): In the open market, the assumption of increased risk would also be compensated by an increase in the expected return, although the actual return may or may not increase depending on the degree to which the risks are actually realised.

Risk in business restructuringsRisk in business restructuringsThree rules of riskThree rules of risk

At conversion one would expectAt conversion one would expect– the variance of LRD returns to be lower the variance of LRD returns to be lower than variance of FFD returnsthan variance of FFD returns

– a reasonable relation between the a reasonable relation between the potential profit given up and and the potential profit given up and and the potential loss hedged.potential loss hedged.

After conversion one would expectAfter conversion one would expect– WACCWACCLRDLRD < WACC < WACCcompanycompany <WACC <WACCPrincipalPrincipal

Proposition for discussionProposition for discussion

In > 50% of all business restructurings, In > 50% of all business restructurings, the rules of risks are denied. the rules of risks are denied.

Case studyCase studyFFD Business ModelFFD Business Model

Operational profitOperational profit

RevenuRevenu

SalesSales

ASP($47,50-$52,50)

ASP($47,50-$52,50)

Sales volume(850k—950k)

Sales volume(850k—950k)

Cost of salesCost of sales

ACP($37,50)

ACP($37,50)

Sales volume(850k-950k)

Sales volume(850k-950k)

OpexOpex

Fixed Opex($5.5m)

Fixed Opex($5.5m)

Variable Opex

Variable Opex

Cost ratio(10%)

Cost ratio(10%) SalesSales

ASP($47,50-$52,50)

ASP($47,50-$52,50)

Sales volume(850k-950k)

Sales volume(850k-950k)

Case studyCase study

Risk distribution FFDRisk distribution FFD

Conversion FFD into commissionaireConversion FFD into commissionaireMidpoint commission rate: 2%Midpoint commission rate: 2%Upper Quartile commission rate: 5%Upper Quartile commission rate: 5%

Options realistically available:

Current situation:

Conversion FFD into commissionaireConversion FFD into commissionaireMidpoint commission rate: 2%Midpoint commission rate: 2%Upper Quartile commission rate: 5%Upper Quartile commission rate: 5%

5% commission rate2% commission rate

Proposition for discussionProposition for discussion

““No routine comparison of profit before No routine comparison of profit before and profit after restructuringand profit after restructuring”, ”, whilstwhilst on the other hand “on the other hand “the taxpayer must the taxpayer must consider the options realistically consider the options realistically available to itavailable to it” is ” is inconsistentinconsistent,,

as an arm’s length consideration of an as an arm’s length consideration of an option will option will alwaysalways comprise the comprise the comparison between profit before and comparison between profit before and after restructuring.after restructuring.

Case study (continued)Case study (continued)Use of WACC to evaluate after conversion TP Use of WACC to evaluate after conversion TP

Value Consolidated

Value Consolidated

Value LRDValue LRD Value PrincipalValue

Principal

Forecast LRD profit

Forecast LRD profit LRD WACCLRD WACC

Forecast Principal profit

Forecast Principal profit

Principal WACCPrincipal WACC

Case study (continued)Case study (continued)

Use of WACC to evaluate after conversion Use of WACC to evaluate after conversion TP TP

Case study (continued)Case study (continued)

Use of WACC to evaluate after conversion Use of WACC to evaluate after conversion TP TP

Case study (continued)Case study (continued)

Solved on commissionaire WACC Solved on commissionaire WACC

Case study (continued)Case study (continued)

Solved on Principal WACC Solved on Principal WACC

Case study (continued)Case study (continued)

Solved on Commissionaire rate Solved on Commissionaire rate

Proposition for discussionProposition for discussion

If in business restructurings the If in business restructurings the benchmark studies were performed on the benchmark studies were performed on the principal’s profit (instead of on the principal’s profit (instead of on the LRD/Commissionaire’s profit), then the LRD/Commissionaire’s profit), then the LRD/Commissionaire’s profit margin would LRD/Commissionaire’s profit margin would be much higher than is currently the be much higher than is currently the case.case.

Proposition for discussionProposition for discussion

Any low risk model is based on the Any low risk model is based on the assumption that an enterpreneur is risk assumption that an enterpreneur is risk averse.averse.

This assumption is not in accordance This assumption is not in accordance with the arm’s length principle, because with the arm’s length principle, because in real economic life enterpreneurs are in real economic life enterpreneurs are risk seeking.risk seeking.