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Solvency Opinions
A solvency opinion is typically issued by a financial advisor for a merger or
acquisition involving a significant amount of debt. It consists of three
financial tests to address a company’s ability to meet debt obligations and
continue operations as a going concern. The opinion is often required by boards
of directors and/or lenders.
Over the past three decades, the importance of solvency opinions has grown
significantly due to the proliferation of the number of leveraged buyouts (LBOs)
transactions. A LBO is a type of transaction in which a company is acquired
using borrowed funds to finance a major portion of the deal price. This deal
structure results in a high level of debt. In certain circumstances such as a
downturn in industry conditions resulting in decreased revenue and cash flow,
debt principal and interest payments can increase the likelihood of financial
distress and threaten the going-concern status of the company.
When insolvency occurs, the company must be reorganized or liquidated. To
minimize the chance of these occurrences following a LBO, a solvency analysis is
needed to determine if the acquired company is left with
- positive equity,
- the ability to pay off its debt on a timely basis; and
- feasible financial means for daily operations
The outcome of the solvency analysis forms the basis of the solvency opinion
with regard to the transaction.
The three conditions studied in a solvency analysis are determined in Section
548 of the U.S. Bankruptcy Code, the Uniform Fraudulent Transfer Act, and the
Uniform Fraudulent Conveyance Act. According to Section 548 of the Bankruptcy
Code, a transfer may be voided if a business entity:
- was insolvent on the date that such transfer was made or such
obligation was incurred, or become insolvent as a result of such
transfer or obligation;
- was engaged in business or a transaction, or was about to engage in
business or a transaction, for which any property remaining with the
debtor was an unreasonably small capital; or
- intended to incur, or believe that the debtor would incur, debts
that would be beyond the debtor’s ability to pay as such debts matured
The three tests to determine conditions 1, 2, and 3 above are the balance
sheet test, the adequate capital test, and cash flow test, respectively. A
company must pass all three tests to be deemed solvent. Basically, the
financial advisor will analyze the debt burden, liquid asset and expected future
cash flow of the company. Due diligence procedures will also involve detailed
analyses of company operations as well as industry, competition and economic
analyses.
Solvency opinions should be rendered by independent financial advisors to
provide investors, board of directors and creditors with unbiased analyses of
the expected financial condition of the company undertaking a highly levered
transaction. The basic purpose of a solvency analysis is to provide information
to these decision makers as to whether it is financially feasible to undertake
the transaction |
