Some Things Just Don’t Add-Up (Q3-17)
Sep 06th, 2017
The following was excerpted from Third Eye Capital Management Inc.’s Q3 2017 Investor Letter.
Ten percent of loans issued in the first half of 2017 to finance M&A transactions had EBITDA multiples of seven times, according to S&P LCD. However, this is understated by the aggressive practice by so many lenders to add-back savings and synergies based on future hopes. While it is customary to adjust for non-cash items and cost reductions when a company goes private, its is disingenuous to add-back amounts, like expected higher margins or potential new contracts, that are based on events planned but may never occur. When Goldman Sachs arranged debt for the $4 Billion buyout of Ultimate Fighting Championship (“UFC”), it allowed add-backs that doubled UFC’s EBITDA. Goldman Sachs was warned by federal bank regulators over the add-backs. Earlier this year, UFC refinanced Goldman Sachs through a loan from KKR Capital Markets (“KKR”), which is not subject to bank regulatory scrutiny. KKR’s first-lien financing for UFC, according to an investor presentation, was based on an adjusted EBITDA of US$320 Million although reported EBITDA for 2016 was US$226 Million. UFC claimed the difference was primarily due to expected cost savings from future plans to reduce labour, marketing, and third-party costs.
Such overt accounting gimmicks have not deterred credit investors. When the private equity firm Hellman & Friedman sought US$265 Million in debt to help finance its purchase of SnapAV, a manufacturer of audio visual products, the add-backs boosted EBITDA by close to a third and reduced leverage to 5.4 times from more than 7 times. Multiple lenders made offers, resulting in a loan with even cheaper pricing than initially discussed and no financial covenants. Perhaps one of the most shocking use of add-backs was a debt financing in February 2017 by GoDaddy, in which lenders allowed the web-hosting and registration service to adjust EBITDA upward for savings and synergies that it does or expects to do in “good faith” over a two-year period.
According to data from Covenant Review, 44% of new loans in Q3-2017 had add-backs without caps or restrictions for synergies and cost savings. So far this year more than 90% of North American bonds had add-backs that were considered “too aggressive” by Moody’s.
Add-backs are not illegal as all adjustments are agreed and laid out in the credit documents. But the aggressive attempt to make borrowers look more creditworthy than they are is understating the amount of leverage in today’s credit markets. Such egregious adjustments are further examples of the reckless habits of some of today’s deal-starved lenders. Either the borrower will need to exceed projections to realize the add-backs, or the lender will be forced to restructure its loan. The latter is substantially more likely but the day of reckoning is far enough out in the future, in large part because of loose covenants, that lenders can enjoy temporary glory in their hyped-up returns.
Our investors know that we believe the next downturn will be painful for a lot of alternative lenders and their clients. Adverse structures, weak protections, and overindulgent add-backs will only exacerbate the potential for losses.