Fuzzy Math That Fuelled Junk Debt Boom Is Sparking Jitters
15 years ago when US mortgage lenders relaxed their lending criteria for individuals with relative low ability to service their debts, they sowed the seeds of the Great Financial Crisis of 2008. This Bloomberg article purports that something similar is happening in the US junk bond market now. (It is interesting how articles on accounting shenanigans are proliferating in the US financial press as highlighted by some of the pieces we have featured in “3 Longs & 3 Shorts” over the past couple of months.)
“…fuzzy numbers may be creating a false perception of safety in the $2.5 trillion market for low-rated corporate debt. That market is a key source of funds for companies with less-than-stellar credit and for private equity firms, which typically load the businesses they acquire with debt to boost returns. Institutional investors have increased their purchases of high-risk loans and bonds over the past decade, as near-zero interest rates made other fixed-income assets less attractive. That demand helped make bigger and riskier loans possible.”
So how are American corporates juicing up their EBITDA? “Ebitda…[is] seen as a relatively direct measurement of a company’s ability to generate cash, because it strips out the effects of management’s decisions on capital investments and indebtedness. In theory it provides evidence of how much money the company could have available to service its debt.
Over the past several years, Wall Street lawyers and advisers have worked to squeeze generous adjustments into the Ebitda calculation, helping make purchase prices look smaller and debt loads more manageable. Exela Technologies Inc., a document processing company formed through the merger of SourceHOV and Novitex, relied on several rounds of adjustments to boost Ebitda when it borrowed money to finance the deal in 2017.
After removing interest, tax, depreciation, and amortization, plus some one-time costs, the company arrived at Ebitda of $247 million. In another round of adjustments, Exela counted expected benefits from shutting offices, cutting workers, and renegotiating vendor contracts. The resulting “further adjusted Ebitda” showed it pulling in $353 million for the 12 months ended on March 31, 2017. Based on generally accepted accounting principles, the combined company would have lost almost $63 million over that period…
In perhaps the most flagrant example of creative Ebitda, office-sharing company WeWork turned a $933 million loss into $233 million of what it called “community adjusted Ebitda” last year, when it issued its debut bond. The widely ridiculed—and since discontinued—metric excluded even basic general and administrative expenses. “We have never seen a net negative adjustment to Ebitda—it only goes up,” says Jason Dillow, CEO of Bardin Hill, a credit investment firm.”
So how significant is the risk posed by EBITDA massaging to the US bond market? “Matthew Mish, head of credit strategy at UBS Group AG, says even a garden-variety recession in the next year or two could cause earnings for the weaker borrowers to drop by as much as 40% from peak to trough, rivaling the declines seen during the global financial crisis. Such a meltdown of corporate balance sheets could fuel a cascade of defaults and bankruptcies….
In the first quarter of this year, companies issuing leveraged loans for mergers and acquisitions inflated their Ebitda by an average 43%, according to Covenant Review, an independent research firm that analyzes debt documents for investors. That’s the highest of any quarter in the data, which dates to 2015.
Evidence suggests that when companies make optimistic adjustments to Ebitda, disappointments are the norm soon after a deal is done. According to a recent study by S&P Global Ratings, companies involved in a merger or a leveraged buyout in 2015 missed their own earnings projections by an average 29% in the first year following the deal. For deals originating in 2016, the projections were off 35%.”