Early-Stage Investments and the ‘Modern’ DCF Method

Introduction

During the early years of international investment arbitration, decision makers found it difficult to quantify the future losses of early-stage investments. The lack of data surrounding these investments and a lack of understanding of economic models and valuation theory led many tribunals to eschew forward-looking models in favour of methodologies that rely on ‘hard figures’ such as sunken costs or wasted expenses. The danger was, and remains, that this approach, albeit more straightforward to apply, can grossly underestimate an investment’s worth and, in turn, unjustly deprive the investor of adequate relief.

As it is generally accepted that the ‘reparation must, as far as possible, wipe out all the consequences of the illegal act and re-establish the situation which would, in all probability, have existed if that act had not been committed’,[2] the use of a valuation method that does not capture the true worth of an investment would itself arguably lead to an inconsistency with customary international law – in much the same way as the ‘easy’ calculation of simple interest would shortchange a claimant compared to an award of compound interest based on classic economic theories.

Enter the traditional discounted cash flow (DCF) model.

As discussed below, the increasing adoption of the traditional DCF method in recent years has allowed tribunals to reliably determine the appropriate relief for investors, even when violations of international law have prevented those investors from realising the potential of their investments. The question, then, is whether the ‘modern’ DCF method (discussed further below) will be received with the same reception as tribunals familiarise themselves with it and the distinct advantages it might offer.

Early-stage international investments

As the liberalisation of international trade and investments continues, we have seen an explosive rise of foreign direct investment in start-ups, greenfield investments and small to medium-scale renewable energy projects. For example, between 2014 and 2018, London became the home of 156 new fintech investment projects funded through foreign direct investment,[3] and Spain averaged 18 greenfield renewable projects a year between 2006 and 2011.[4] Many of these projects are being incentivised with subsidies and other favourable regulatory features for the specific purpose of attracting foreign direct investment.

But, as many foreign investors (e.g., investors in the Spanish renewables sector reliant on state subsidies) have learned the hard way, things may change in an unanticipated manner after the investor has undertaken a significant commitment in reliance on the state’s promises. The state may subject investments to changes in regulation and other state acts that could render a project worthless. This has been the basis for numerous claims under international investment agreements for several years and multiple awards of damages.

If the investment is considered early-stage or a business or investment that does not have a significant history of ongoing business operations, typically measured as less than five years,[5] the valuation may be subject to certain challenges. These investments may potentially be lucrative, but many have yet to produce steady revenue, and in many instances will still be in the process of repaying the financing received to initiate the project. Aside from forecasts, there may be little to no financial data in the company’s history that can serve as a basis to quantify the loss of future profits. That being said, although there may be some difficulty in determining reliable metrics for this purpose, the task is not impossible.

Continuous trend towards the DCF method

Calculation of fair market value

When a tribunal endeavours to calculate damages[6] owed to an aggrieved investor based on the fair market value of the investment, as is generally envisaged by investment treaties and accepted by arbitral tribunals,[7] the tribunal must determine which model is appropriate to quantify an investment’s value as at the date of valuation. The tribunal in Crystallex v. Venezuela, for instance, was presented with four methods by which to calculate damages deemed to have resulted from Venezuela’s breach of its treaty obligations. Before delving into an analysis of which method to apply, the tribunal noted that there is no one-size-fits-all approach to valuations, stating:

Tribunals may consider any techniques or methods of valuation that are generally acceptable in the financial community, and whether a particular method is appropriate to utilize is based on the circumstances of each individual case. A tribunal will thus select the appropriate method basing its decision on the circumstances of each individual case, mainly because a value is less an actual fact than the expression of an opinion based on the set of facts before the expert, the appraiser or the tribunal.[8]

Of the three traditionally used methods for calculating an investment’s value, the forward-looking, income-based DCF method is a logical fit for early-stage companies that have yet to reach a stable level of growth. The market-based method could fail to capture the value of an early-stage investment owing to the absence of any comparable investments for valuation purposes. The cost-based method only takes into account prior expenses. By contrast, the DCF model measures value at a given date based on projected future cash flows that income producing assets are expected to generate. These projected income streams are then appropriately discounted to produce a value at the given date that takes account of the risks inherent in such projections and the time value of money. For investments that do not have significant start-up expenses or for which there is no true market comparison, the DCF method is a model that can be used to calculate the value of a project based on its potential future profitability.

Growing preference for DCF method

There has been a recent trend towards the use of the DCF method by international investment tribunals. According to research by Burford Capital and Versant Partners regarding the three traditional valuation methods (DCF method, market-based approach and cost-based approach):[9]

  • approximately 54 per cent of investment treaty awards rendered in favour of the investor in 2019 used the DCF method as the basis of calculation;[10]
  • only 23 per cent of awards in that same group employed the cost-based approach, whereas a mere 3 per cent used a market-based approach;
  • approximately 20 per cent of awards in that same group relied on an alternative to the traditional three; and
  • the preference towards the DCF model is relatively recent; in 116 pre-2017 awards surveyed, only 40 per cent of tribunals applied the DCF method, whereas 32 per cent used backward-looking models and 10 per cent used a market-based approach.[11]

Tribunals have explicitly confirmed this development in their decisions. According to the tribunal in Rusoro v. Venezuela, ‘[v]aluations based on the DCF method have become usual in investment arbitrations, whenever the fair market value of an enterprise must be established’.[12] It continued, ‘where the circumstances for its use are appropriate, forward-looking DCF has advantages over other, more backward-looking valuation methods’.[13]

However, tribunals’ preference for the DCF methodology looks different when the 2019 awards are broken down according to the life cycle of the investment that gave rise to the damages awarded. For early-stage investments, qualified as those with no more than five years of operation, tribunals applied a cost-based method in 80 per cent of cases, whereas 60 per cent of mature investments with more than five years of operating history were valued with the DCF model.

The ‘modern’ DCF method

A potential alternative for valuing early-stage investments

Enter the ‘modern’ DCF method, which has come into public view since its application in Tethyan v. Pakistan.[14]

The ‘modern’ DCF method has previously appeared under other aliases. The Tethyan tribunal acknowledged that the ‘modern’ DCF method advanced in that case shares elements with what the Canadian Institute of Mining, Metallurgy and Petroleum Special Committee on Valuation (CIMVAL) has labelled the Certainty-Equivalent DCF approach (or the CeQ DCF for the initiated).[15] For those willing to continue down the rabbit hole, the method can be traced back even further to Michael J Brennan and Eduardo S Schwartz’s 1985 article, ‘Evaluating Natural Resource Investments’.[16] Following publication of that article, the approach initially came to be known as the ‘real options’ approach.[17]

Putting matters of nomenclature to one side, the chief difference between the ‘modern’ and traditional DCF methods lies in the treatment of risk. As alluded to above, under the traditional DCF method of damages valuation, the future net operating cash flows that an investment was expected to generate are adjusted to reflect their present value by applying a constant, compounding discount rate. In addition to reflecting the time value of money, this discount rate has the purpose of capturing cash flow risk. The application of this single, aggregate discount rate to the entirety of the expected cash flows assumes (for valuation purposes at least) a certain uniformity of risk over the entirety of the forecasted period.

By contrast, the ‘modern’ DCF method eschews the application of a single measure of risk to the entirety of the cash flows.[18] Instead, the cash flows are profiled to allow for risk adjustments to be applied to discrete cash flow streams. Having made individual risk adjustments to the various future cash flow streams themselves, a risk-free rate is applied to account for the time value of money and thereby discount those cash flows to reflect their present value. In some instances, the risk-adjusted cash flows may also be subjected to ‘a residual risk adjustment for uncertainties not explicitly accounted [for] in the cash flow model’.[19]

One of the chief innovations of the ‘modern’ DCF method is the application of an additional element – option pricing theory – to model cash-flow risk that arises from changes in the prices of a traded asset. For this reason, it may have particular relevance for both natural resource extraction projects (in which the futures prices of the traded mineral or hydrocarbon can serve as a basis for modelling the cash flows generated by the project) and power generation projects (in which the futures prices of the power generation source – such as coal or gas – can serve as the basis for modelling the cash flows generated by the plant).[20]

The tribunal in Tethyan v. Pakistan identified itself as the first international investment arbitration tribunal to have (at least publicly) adopted the ‘modern’ DCF method as a basis for awarding damages.[21] The claimant, Tethyan Copper Company Pty Limited (Tethyan), brought a claim against Pakistan for the denial of a mining licence. Tethyan alleged that the denial of the mining licence deprived Tethyan of the future profits that it would have realised from the exploitation of a mine at Reko Diq, in the Pakistani province of Balochistan.[22] In the arbitration, Tethyan relied heavily on a feasibility study that it had provided to the government of Balochistan, assessing the economic, financial and technical feasibility of a base case mining project and contemplating its future expansion.[23] This study envisaged a 56-year life of the mine.[24]

Tethyan’s expert proposed the ‘modern’ DCF method of valuation as the proper way to assess the damages owed by Pakistan. Instead of assessing the entirety of the expected future free cash flows and subsequently applying a risk-based discount rate, Tethyan’s expert separated out the different sources of projected income, used forward markets to adjust each expected cash flow component for the risks that affected that particular cash flow, and then applied a risk-free discount rate.[25] Critically, this led the claimant’s expert to arrive at a positive net present value of the investment. The tribunal observed that, according to the claimant’s expert’s analysis, cash flows to be generated 40 years into the future would have had ‘almost no net present value’ when calculated under the traditional DCF method.[26]

The claimant’s expert identified ‘four main shortcomings’ of the traditional DCF method when applied to the calculation of the fair market value of long-life mining projects:

(i) there is no market-based information for the main price and cost drivers of the project for 50 years of more into the future; (ii) there is no reasonable way of knowing how the market would discount the risk in each cash flow for a specific mining project but the standard approach uses market signals from the market industry as a whole and uses a constant risk-adjusted discount rate which compounds over the years even though the risk of long-life mining projects is more or less constant over time; (iii) the method underestimates the project’s tax cash flows and therefore overestimates net cash flows; and (iv) there is no simulation accounting for the possibility of the project’s managers to respond to changing conditions by making appropriate operational decisions.[27]

By contrast, the claimant’s expert identified the advantages to the ‘modern’ DCF that allowed it to simulate key project variables and thereby capture the impact of taxes and active management decisions on cash flows:

First, it uses forward market transactions as a signal of market participants’ expectations about future mining prices and costs along with their risk preferences over the uncertainty in those prices and costs. Second, it simulates over a wide range of possible cash flow outcomes in order to correctly capture the varying impacts of taxes and managerial actions on the project’s expected net cash flows. The use of forward markets to assess project cash flow risk is the most profound change, doing away with the overall, exogenously imposed and often highly contentious project level discount rate. In this sense it is a true market-based approach that provides a market asset valuation, exactly what is desired for a [fair market valuation].[28]

The tribunal characterised its task of damages valuation as that of ‘mak[ing] the best estimation of what, on the assumption that Respondent had honored its Treaty obligations, would actually have happened if Reko Diq had been offered for sale in the open market’. That tribunal noted further that ‘[i]f in practice a buyer was most likely to have adopted the methodology recommended in the CIMVAL opinion, it is irrelevant that an expert considers that some other methodology would have been better’.[29]

The Tethyan tribunal analysed whether the risk adjustments made by Tethyan’s expert were sufficient in its ‘modern’ DCF calculation to account for the fluctuation of prices during the 56-year life of the mine, and also took into account the comparison drawn by Pakistan’s experts to the traditional DCF calculation.[30] On this basis, the tribunal reduced Tethyan’s expert’s valuation by making two additional risk adjustments[31] and awarded the claimant more than US$4 billion in damages.[32]

The tribunal was not deterred by the lack of previous public investment treaty jurisprudence on the ‘modern’ DCF method:

[T]he absence of investment treaty jurisprudence – affirmative or negative – does not in itself constitute a valid ground for rejecting a valuation method if the Tribunal is otherwise convinced that it is sound to apply it in the present case. . . . As correctly pointed out by Claimant, the use of the traditional DCF method was even rejected in early jurisprudence but then became more and more common and established for the assessment of damages in investment treaty arbitration.[33]

The Tethyan award does not necessarily signal the acceptance of the ‘modern’ DCF method in investment arbitration. Pakistan has initiated annulment proceedings on grounds that the tribunal ‘fell into annullable error’ by adopting the ‘modern’ DCF approach[34] (among other alleged defects). Pakistan argues that the tribunal (1) manifestly exceeded its powers ‘due to a failure to apply the proper law because, as a matter of principle, and at least as the Tribunal in this case applied it, the “modern DCF approach” egregiously failed to satisfy the legal standard of “sufficient certainty”’;[35] (2) failed to state reasons in support of applying a test of ‘fundamental uncertainty’ rather than ‘sufficient certainty’;[36] and (3) ‘failed to state reasons’ insofar as its reduction of the claimant’s original valuation ‘by more than 50%’ contradicted the tribunal’s finding that the risks and uncertainties of the project and its profitability were not fundamental.[37]

Pakistan specifically attacks the ‘modern’ DCF method as being ‘highly speculative – far more so than a traditional DCF valuation’,[38] and essentially, its challenge rests on whether the projected cash flow was too speculative to be protected under international law. Essentially, Pakistan updates a classic argument to argue that the ‘modern’ DCF method – at least as applied to the facts in Tethyan – is too speculative to serve as a basis for calculating damages.[39]

Conclusion

It remains to be seen whether the ‘modern’ DCF method will continue to make inroads in investment arbitration. Its application to a long-term mining project in Tethyan is a significant first step (Pakistan’s annulment application notwithstanding) but time will tell whether and how quickly other tribunals adopt it. Should it benefit from the gradual but steady reception that has graced the traditional DCF method, it, too, may find applications to ‘a wide variety of contexts outside the natural resource sector where uncertainty about future project revenues is a paramount concern’,[40] as envisaged by the originators of the ‘modern’ DCF (or real options) method back in 1985.


Notes

[1] Tunde Oyewole and Sarah Stockley are senior associates and Charles Adams is a partner at Orrick Herrington & Sutcliffe LLP. The authors are grateful to Sarah Lajugie (associate) and Sara Little (trainee) for their assistance with this chapter.

[2] Factory at Chorzow (Germany v. Poland) (Merits) PCIJ Rep. Ser. A. (No. 17) (13 September 1928), page 47.

[3] Naomi Davies, ‘Fintech Locations of the Future 2019/20: London tops first ranking’, FDI Intelligence, (15 August 2019); see also Erik Canton and Irune Solera, ‘Greenfield Foreign Direct Investment and Structural Reforms in Europe: What Factors Determine Investments?’, Discussion Paper (June 2016), at https://ec.europa.eu/info/sites/info/files/dp033_en.pdf.

[4] Sebastian Shehadi, ‘Spanish Renewables see increased FDI in 2018’ (4 October 2018); see also Canton and Solera (footnote 3, above).

[5] Jeffery Commission (Burford Capital), Kiran Sequeira (Versant Partners), Garret Rush (Versant Partners), ‘Burford Briefing: Year-in-Review: Arbitration Finance and Damages’ (2020) (PowerPoint presentation), at https://www.burfordcapital.com/insights/insights-container/year-in-review-arbitration-finance-and-damages/ (last accessed 29 September 2020); cf. ‘“Going Concern” as a Limiting Factor on Damages in Investor-State Arbitrations’, Jose Alberro and George D. Ruttinger, The Journal of Damages in International Arbitration (2015) Vol. 2 No. 1, p. 1.

[6] Tethyan Copper Company Pty Limited v. Islamic Republic of Pakistan, ICSID Case No. ARB/12/1, Award, 12 July 2019, para. 348 (A tribunal’s task when calculating damages is to ‘make the best estimation of what, on the assumption that Respondent had honored its Treaty obligations, would actually have happened if [the investment] has been offered for sale in the open market’.).

[7] See, e.g., United States – Uruguay BIT, Article 6.1 and 6.2 (‘1. Neither Party may expropriate or nationalize a covered investment . . . , except . . . (c) on payment of prompt, adequate and effective compensation; . . . 2. The compensation referred to in paragraph 1(c) shall: . . . (b) be equivalent to the fair market value of the expropriated investment’; See also ConocoPhillips Petrozuata B.V., ConocoPhillips Hamaca B.V. and ConocoPhillips Gulf of Paria B.V. v. Bolivarian Republic of Venezuela, ICSID Case No. ARB/07/30, Award, 8 March 2019, para. 199 (in which the tribunal noted that the most common method for calculating the value of an investment is to determine its fair market value); Energy Charter Treaty, Article 13, para. 1, which states that compensation for expropriation ‘shall amount to the fair market value of the Investment expropriated at the time immediately before the Expropriation’.

[8] Crystallex International Corporation v. Bolivarian Republic of Venezuela, ICSID Case No. ARB(AF)/11/2, Award, 4 April 2016, para. 886.

[9] Commission, Sequeira, Rush (footnote 5, above).

[10] Jeffery Commission (Burford Capital), Kiran Sequeira (Versant Partners), Garret Rush (Versant Partners). (2020). ‘Burford Briefing: Year-in-Review: Arbitration Finance and Damages’ [PowerPoint presentation]. (Accessed: 29 September 2020).

[11] id.

[12] Rusoro Mining Ltd. v. Bolivarian Republic of Venezuela, ICSID Case No. ARB(AF)/12/5, Award, 22 August 2016, para. 758.

[13] id.

[14] Tethyan Copper Company Pty Limited v. Islamic Republic of Pakistan, ICSID Case No. ARB/12/1, Award, 12 July 2019, para. 359.

[15] id., at para. 350 (citing a 2012 letter from the Special Committee of the Canadian Institute of Mining, Metallurgy and Petroleum on Valuation of Mineral Properties [CIMVAL] to the International Valuation Standards Council, p. 5 (CIMVAL 2012 Letter available at https://www.ivsc.org/files/file/download/id/337)).

[16] Michael J Brennan, Eduardo S Schwartz, ‘Evaluating Natural Resource Investments’, Journal of Business, 1985, Vol. 58, no. 2, available at https://www.jstor.org/stable/2352967?seq=1.

[17] Since writing the CIMVAL 2012 Letter cited in Tethyan, CIMVAL has reverted to the ‘classical’ term: the 2019 CIMVAL Code for the Valuation of Mineral Properties refers to the method as the ‘real options’ valuation method, rather than the ‘certainty-equivalent DCF approach’.

[18] See CIMVAL 2012 Letter, p. 5; see also Tethyan Copper Company Pty Limited v. Islamic Republic of Pakistan, ICSID Case No. ARB/12/1, Award, 12 July 2019, para. 350.

[19] See CIMVAL 2012 Letter, p. 5.

[20] See Brennan and Schwartz (footnote 17, above), at pp. 135 to 138.

[21] Tethyan Copper Company Pty Limited v. Islamic Republic of Pakistan, ICSID Case No. ARB/12/1, Award, 12 July 2019, para. 359.

[22] id., at para. 86.

[23] See Tethyan Copper Company Pty Limited v. Islamic Republic of Pakistan, ICSID Case No. ARB/12/1, Decision on Jurisdiction and Liability, 10 November 2017, para. 482; and Tethyan Copper Company Pty Limited v. Islamic Republic of Pakistan, ICSID Case No. ARB/12/1, Award, 12 July 2019, para. 355.

[24] Tethyan Copper Company Pty Limited v. Islamic Republic of Pakistan, ICSID Case No. ARB/12/1, Award, 12 July 2019, para. 355.

[25] See id., at para. 343 (‘In short, Prof. Davis stated that he applied at-source pricing of risk using forward markets, thereby avoiding the use of a constant risk-adjusted discount rate, and simulated key project variables to capture the impact of taxes and of active management decisions on cash flows and thereby project value. As he considers to have included all relevant risks in the cash flows themselves, he discounts the cash flows at the risk-free rate.’).

[26] id., at para. 355.

[27] id., at para. 340.

[28] id., at para. 342.

[29] id., at para. 348.

[30] id., at para. 1477.

[31] id., at paras. 1521 (reduction with regard to the systematic risk of fluctuations in the prices for copper, gold and oil), 1544 (reduction with regard to the risk of increases in capital and operating expenditures (other than oil)), 1596 to 1597.

[32] id., at para. 1601.

[33] id., at para. 360.

[34] Tethyan Copper Company Pty Limited v. Islamic Republic of Pakistan, ICSID Case No. ARB/12/1, Request for Annulment of the Award dated 12 July 2009, 8 November 2019, para. 103.

[35] id., at paras. 94, 98 to 99.

[36] id., at paras. 94 and 100.

[37] id., at paras. 94 and 101.

[38] id., at para. 98.

[39] id., at para. 95 (Pakistan cites the Commentary to Article 36 of the International Law Commission’s Articles on the Responsibility of States for International Wrongful Acts, which in Pakistan’s submission ‘states that lost profits are “inherently speculative” and “vulnerable to commercial and political risks, and increasingly so the further into the future projections are made”, and are only awarded where “an anticipated income stream has attained sufficient attributes to be considered a legally protected interest of sufficient certainty to be compensable”’.).

[40] See Brennan and Schwartz (footnote 17, above), at p. 135 (‘The approach may be adapted to a wide variety of contexts outside the natural resource sector where uncertainty about future project revenues is a paramount concern.’).

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