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‘Fake EBITDA’ to worsen next slump, $33 billion debt maven warns

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Alan Waxman was just 31 when he made partner on a Goldman Sachs team that bet the firm’s own cash for wild profits. He later co-founded TPG Sixth Street Partners and helped build it into a $33 billion force in credit markets.

Now he’s raising alarms about those same markets.

In a private conference earlier this week, Waxman, 45, warned investors there’s an epidemic of fake earnings projections that will be exposed in the next economic slump and may even exacerbate it. Too many companies are addicted to making creative accounting adjustments that bump up operating profits known as EBITDA – and investors are turning a blind eye, he said, according to a person with knowledge of his comments.

“It’s not normal, as a lender, to lend money against fake EBITDA and fake collateral,” he said in the presentation.

In theory, lenders focus on EBITDA –- an acronym for earnings before interest, taxes, depreciation and amortization – to get a clear sense of a company’s financial health before it pays down its debts. Yet suspicions have mounted in recent years that some executives are padding their projections for EBITDA. In 2017, one Moody’s analyst coined a new definition for EBITDA: Eventually busted, interesting theory, deeply aspirational.

Much of the consternation focuses on adjustments known as “add-backs,” in which companies exclude certain expenses from future earnings. A traditional add-back, for example, could account for the expected savings from a cost-cutting program. But some companies have resorted to creative or aggressive items with descriptions that can be difficult to understand. Last year, a Federal Reserve official called out the use of add-backs as an area of mounting concern.

Inflating EBITDA distorts the loan-to-value ratio that guides the $2.9 trillion market for junk bonds and loans in the U.S. and Europe, he said. Part of the problem, Waxman said in his presentation, is that investors have tolerated so much deviant behavior that it has become normalized.

Some companies and their private-equity owners are goosing projections and presenting assumptions about returns that are more aggressive than their own internal models, he said. One alarming stat he points to: More than half the companies that were part of a leveraged buyout in 2016 missed their earnings projections by more than 25% last year. And that’s in a growing economy.

The result is that in many cases creditors actually have a smaller cushion between the last dollar of risk they take and the real value of the company to which they lend, he said. There’s also a risk investors are committing capital based on an available pool of collateral that could disappear because of the lack of restrictive covenants that have historically protected lenders – “fake collateral”, as Waxman put it.

“The sacred lending principle of loan-to-value integrity is the single most important thing in credit investing,” he said. “When it is severely compromised, as it is now, credit stops being credit. It’s just cheap capital.”

Waxman helped start his firm in 2009, a year after leaving Goldman Sachs Group Inc., with $2 billion from buyout fund TPG and much of his old team from Goldman. At the time, it was called TPG Opportunities Partners. Now often referred to as TSSP, the firm has returned 20% annualized, before fees, over the last decade.

One prominent example of a company whose figures have confounded investors in recent times was office-sharing firm WeWork, which became known for its reliance on an unconventional accounting metric known as “community-adjusted EBITDA.” The company said it captured the profitability of WeWork locations, excluding general and administrative expenses. But the benchmark was questioned by analysts after it first came up in financial documents tied to a 2018 bond sale. It surfaced again in early drafts of the company’s S-1 filing for a public stock debut, only to be omitted from the final version.

“The party will go on in the leverage finance markets until we have a catalyst,” Waxman told investors.

The catalyst will most likely come from the BBB-rated credit market, where 43% of debt is levered over 4 times, according to Waxman. About 70% of that universe is at risk of losing its investment grade status, he said. Once that happens, the quantity of debt will overwhelm the high-yield market and create substantial dislocations, he said.

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