Forecasting Follies: Unmasking Bias in Financial Projections

By Jessica Liou, Alexandra Langmo, Sayre Powers and Manish Kumar

Financial projections play a critical role in high-stakes transactions. Courts, creditors and other stakeholders rely on these forecasts to assess solvency, determine enterprise value and make informed decisions about a company’s future. How reliable are these projections? What factors do courts look at to determine whether they are reasonable, or dangerously optimistic? This article explores the frameworks that courts use to determine the reliability and reasonableness of projections that are challenged.

Inherent Bias Might Be Embedded in Projections

Those who would prepare future cash flow analyses and discount them to present values are not oracles.1

Valuation is not an exact science, and financial projections do not follow a standard formula.2 They are inherently subjective endeavors, shaped by the data selected, the assumptions applied, and — critically — the strategic purpose they are intended to serve. The motivations of the party preparing the projection can often influence the outcome: Sell-side projections might be overly optimistic to attract buyers and maximize value, while a buy-side projection could come across as overly conservative to support a specific capitalization proposal. Banks preparing projections for credit analysis might emphasize specific risk factors to justify more restrictive lending terms, while ordinary-course budgetary projections used to operate a business might reflect management’s realistic expectations based on historical performance.

The fact that projections are shaped by such a wide range of assumptions and variables makes them particularly vulnerable to challenges. Understanding how courts evaluate the reliability and credibility of projections offers valuable insights for professionals across industries. This article highlights certain key considerations that influence whether a court finds projections to be credible.

Projections Not Supported by Third-Party Expert Analysis

Whether in the context of plan feasibility under chapter 11 or valuation disputes in mergers and acquisitions, courts have shown a consistent willingness to scrutinize — and even reject — management projections that are not supported by independent, third-party analyst reports. For example, the court in In re Paragon Offshore PLC3 held that a chapter 11 plan filed by Paragon (a global provider of offshore oil rigs) was not feasible because the realities of the market for oil rigs would put too much pressure on Paragon’s cash flow post-reorganization.4 The court observed that Paragon was unlikely to achieve the day rates and rig-utilization levels that management projected.

Paragon admitted during trial that they had been bidding for projects below the day rates suggested in the downside analysis.5 Neither Paragon nor its advisor consulted any independent third-party reports to substantiate the day-rate assumptions underlying the downside scenario. The court specifically noted the existence of several readily available analyst reports that contradicted Paragon’s outlook, further calling into question the reliability of the projections.6

In In re Genco Shipping & Trading Ltd., the debtors (who operated in the dry-bulk-shipping industry) retained Marsoft (an independent maritime consultancy) to support the projected shipping prices forecasted in their projections. Marsoft conducted a comparative analysis showing the historical accuracy of their forecasting against 10-year average rates. The court ultimately found Marsoft’s analysis more persuasive, citing both the rigor of its methodology and the firm’s credibility. With nearly 30 years of experience and more than 100 clients, the court noted that Marsoft had “staked its reputation — and the success of its business — on providing objective, nonbiased forecasting in the dry-bulk industry.” The court further observed that “Marsoft has nothing to sell other than its accuracy.”7 In contrast, the court questioned the forecast of the equity committee’s expert, who based his valuation on projections from sell-side equity analysts, all of whom had incentives to present overly optimistic outlooks to support securities sales in the shipping sector.8

The Paragon and Genco cases demonstrate how the use of independent third-party expert analysis can bolster the reliability of projections.

Projections Prepared in Anticipation of Litigation

When financial forecasts appear tailored to support a legal position, the credibility of the projection can erode. In In re Nellson Nutraceutical Inc.,9 all three experts in the case based their valuation conclusions on the debtors’ long-range business plan. However, the court found that the evidence at trial established that the plan was not management’s genuine assessment of the company’s financial outlook. Rather, the plan was shaped in advance of the litigation with the direction and pressure of the debtors’ controlling shareholder to inflate the perceived value of the debtors’ business.10 As such, the court observed that “[a]s a direct result of the fact that the experts’ conclusions as to enterprise value are based upon the unrealistic [business plan], all of the experts have necessarily arrived at concluded enterprise values for the debtors that are themselves somewhat unrealistic.”11

Courts are especially skeptical of experts that change their opinion to support a particular litigation outcome. In Weisfelner v. Blavatnik (In re Lyondell Chem. Co.),12 the court found that the trustee failed to prove his fraudulent-transfer case because, among other things, his expert was unreliable. Pre-merger, the trustee’s expert concluded that management’s projections were “more bullish” but still conservative. Post-merger, when the same expert was retained by the trustee for the purposes of the fraudulent-transfer litigation, he concluded that management’s projections were materially overstated.13

More significantly, the expert’s projections developed for litigation purposes were fundamentally at odds with the expert’s earlier projections developed on behalf of a separate entity that was interested in a potential transaction involving Lyondell (and such projections were relied on by the banks in committing billions of dollars in merger financing). Because the expert’s opinions changed with each engagement,14 the court concluded that the expert’s credibility was seriously compromised, thus his after-the-fact litigation projections were also unreliable.

An expert’s credibility and a projection’s credibility often rise and fall together, especially in contexts shaped by a party’s litigation strategy. Courts are wary of valuations that appear more like advocacy than objective analysis, and forecasters should ensure that they corroborate their assumptions using multiple methodologies and independent expert input. They should also be prepared to justify their reasoning behind their selection of methodologies, assumptions and underlying facts at the outset of their involvement, then think critically and defensively about potential challenges when preparing projections to minimize the risk of challenge and/or rejection.

Projections of Businesses in New, Volatile or Cyclical Industries

Courts have recognized the difficulty of making reliable projections for businesses in new, volatile and cyclical industries. In Doft & Co. v. Travelocity.com Inc.,15 the court rejected the discounted-cash-flow (DCF) methodology primarily because there was an absence of reasonably reliable contemporaneous projections, given the new and volatile nature of the industry. The court explained that the “degree of speculation and uncertainty characterizing the future prospects of [the company] and the industry in which it operates make a DCF analysis of marginal utility ... [because] the industry was so new and volatile that reliable projections were impossible ... it was difficult to forecast the next quarter, let alone five years out.”16

Similarly, in In re Chemtura Corp.,17 the court evaluated competing valuation analyses in the context of plan confirmation and ultimately rejected the valuation submitted by UBS on behalf of the equity committee, opting instead for the analysis offered by Lazard, the debtors’ financial advisor. Chemtura was a global manufacturer that operated in industries that were inherently cyclical (e.g., the agricultural industry). Lazard presented a blended valuation based on DCF, comparable companies and precedent transactions analyses. In contrast, UBS relied exclusively on DCF and only used the other methods as a so-called “sanity check” on its DCF-derived value.18

The court questioned the approach of UBS. It pointed out that DCF is especially sensitive to the assumptions embedded in forward-looking projections that, in this case, were already viewed as optimistic.19 The court expressed concern that UBS relied on a high terminal value drawn from the final year of an aggressive growth forecast, noting that while such an approach might be reasonable in a stable economy, it was “too aggressive” given the prevailing economic uncertainty.20 In this context, the court suggested that an analysis of comparable companies might be a more reliable indicator of value than a DCF or comparable-transactions analysis because it is less susceptible to uncertainties in projections (in the case of DCF) or such extraneous factors as control premiums, synergies or bidding wars (in the case of comparable transactions).21

The Genco22 court similarly scrutinized the use of DCF analysis, emphasizing that a credible DCF analysis depends on reliable long-term projections, which were absent in this case. Genco operated in the dry-bulk-shipping industry, which, according to the court, has rates that are extremely difficult to predict and can change drastically in a single day.23 While the court found several problems with the analysis, it noted that the “volatility of the industry is a sufficient basis by itself to reject a DCF analysis.”24

The case law suggests that in sectors where future performance is especially difficult to predict, forecasters should acknowledge the uncertainty and carefully select valuation methodologies that reflect the available data. Courts are more likely to reject speculative DCF projections.

Considerations for Valuing Start-Ups

Start-up companies also present unique valuation challenges due to their lack of operating history and revenue stream. Commenting on a debtor’s expert testimony concerning the feasibility of a chapter 11 plan proposed by a start-up company, one court remarked that the testimony “sounded a bit like a popular Bon Jovi song ... ‘I’m halfway there, woah living on a prayer.’”25

Given that start-ups lack established historical revenue, courts typically reject the use of DCF analysis and have favored market-based approaches for valuation. For example, the In re DBSD N. Am. Inc.26 court rejected DCF analyses for a debtor satellite start-up where one expert relied on negative-cash-flow projections for four years and the other relied on projections from a business plan assuming a $1.5 billion capital investment that would not materialize.27 The court instead adopted the comparable companies analysis, where value is calculated by examining the value of comparable publicly traded companies for which economic data is readily available.28

Other challenges can arise when attempting to value a start-up that has yet to generate any revenue. In re White29 involved a fraudulent-transfer action commenced by a chapter 7 trustee. The court found that the plaintiff/trustee failed to show that the debtor’s interest in the transferred start-up company had any value, as the company did not have a finished product, state approval, sales, contracts or sufficient personnel.30 The court noted that when valuing a start-up or “pre-revenue company,” courts should consider that the start-up’s value does not lie in the idea itself, but in the company’s ability to execute the idea, which depends heavily on the strength and capability of the team. Furthermore, since these ventures often involve significant uncertainty, courts should apply an appropriate discount rate to reflect the heightened risk.31

Additional Considerations in Periods of Crisis and Uncertainty

Periods of financial crisis and extraordinary uncertainty bring about additional challenges to valuations that also should be considered. Disruptions such as tariffs, pandemics like COVID-19, and financial crises can significantly impact a company’s financial performance and forecasts.

To manage the uncertainty associated with these extraordinary events, companies should employ scenario analysis, developing multiple scenarios based on different potential impacts on costs and revenue. Sensitivity analysis can help identify how changes in these factors affect financials, focusing on managing the key variables most impacted. Continuously monitoring developments and adjusting projections accordingly is crucial. When considering the appropriate scenario, one might want to consider facts that are known and/or knowable as of the measurement date to increase the reliability of the scenarios.

Conclusion

Financial projections involve inherent uncertainty. However, across a wide range of fact patterns, courts have consistently emphasized that reliable projections stem from a rigorous process led by independent experts. Practitioners should carefully examine industry dynamics and broader macroeconomic conditions to ensure that the assumptions underlying their forecasts present an accurate and defensible view of future business performance. Ultimately, the strength of a projection lies not in its precision, but in the credibility of the process behind it.

Jessica Liou is a partner, and Alexandra Langmo is an associate, with Weil, Gotshal & Manges LLP’s Restructuring Department in New York. Sayre Powers is an associate in the firm’s Houston office. Manish Kumar is a managing director with Province LLP in New York. Ms. Liou and Mr. Kumar are advisory board members of ABI’s VALCON program.