1/7/20
Today’s (i.e., 1/7/20’s, page B1) Wall
Street Journal contains an article reporting (summarizing, really)
the travails of the leveraged-loan market. In this context, the term leveraged-loans,
for those of you who are not that deeply interested in finance, is applied to
ostensibly senior, variable rate loans made to less credit-worthy
companies. Though they would generally
be made to the same companies, or at least to companies with the same credit
ratings, that issue high yield, or junk, bonds, leveraged loans are distinguished
from junk bonds in that, first, they are loans, not privately or publicly
issued bonds, and, second, the loans are technically senior to the junk
bonds of the same issuer.
The article reports, as people who follow such things
know, that the leveraged loan market is in a bit of trouble and may be foreshadowing
difficulty for the overall markets and economy. In fact, at the beginning of December of last
year, 2.5% of such loans were trading at less than 70% of face value. At first glance, to the casual observer, 2.5%
of such loans showing signs of duress doesn’t sound bad. But when one considers that these are
variable rate, senior loans that are designed to maintain a value of par, or
face value, and that the 2.5% number hasn’t been hit since the third quarter of
2016, the troubles afoot in the leveraged loan market are real.
The article reports that most observers attribute this leveraged
loan trouble to, of course, declining credit quality. Without getting too arcane, two primary indicators
of declining credit quality in this instance are a lack of covenants in the
leveraged loan contracts and expanding leverage, or debt, ratios. The relevant debt ratios in these instances
are calculated by dividing the total debt of the issuer by the issuer’s
operating cash flow, or earnings before interest, taxes, depreciation, and
amortization, or EBITDA. These numbers
apparently sounded, when first proposed, much more conservative than they turn
out to be. This appearance of
conservatism, or at least not outrageousness (if “outrageousness” is not just a
word yours truly has made up), arose because issuers inflated their projections
for sales, margins, etc., thus inflating projected EBITDA. Such creative inflations of EBITDA are
called “EBITDA add-backs.”
If you’re still reading, please stay awake; this gets
more interesting…
This article elicited several thoughts from yours truly, one
of which actually has something to do with the subject matter and others of which
are more entertaining, and one of those (the third) has absolutely nothing to
do with the subject matter:
First, a long time ago, when yours truly knew everything
and was nearly of consequence in the junk bond market, I was one of the guys
who developed the now simple concept, referred to above, of earnings before
interest, taxes, depreciation, and amortization.” We used this concept to analyze companies,
like cable companies, which were all the rage back in the early ‘80s, which had
no GAAP earnings but generated plenty of cash.
And this wasn’t just a rationalization for doing deals that shouldn’t
have been done; even though these companies were, strictly speaking, unprofitable,
their enormous cash flows made them nearly immensely credit-worthy and, at the
interest rates we were getting for our shareholders, great deals.
While I was one of the originators of the concept of EBITDA,
I steadfastly rejected, and continue to reject, the cutesy-pie quasi-acronym “EBITDA,”
(long E-BIT-DAH) that is used for the sake of brevity by just about
everybody who deals with this concept. EBITDA
sounds like something one would hear at either a nursery school or a well-oiled
saloon about an hour before closing time.
At any rate, due to the offense this term causes to the ears, yours
truly insists on actually saying “earnings before interest, taxes, depreciation
and amortization” or simply “operating cash flow” when referring to what the
world insists on calling “EBITDA.”
Since the latter can be confusing, or at least misconstrued for reasons from
which I will spare you, I usually resort to the former, which elongates the
classes I teach but which maintains my dignity and that of my students.
Second, the capacity in which I helped develop the now Frankensteinian
EBITDA was as a junk bond credit analyst at a major money manager, my first “real”
job in the investment world. Back then,
we ran a lean ship, a couple of portfolio managers and a few more credit analysts,
the latter including the young but nonetheless quite full of himself yours
truly. All of us, portfolio managers
and credit analysts, reported to a very senior guy whose name I can’t use
because I haven’t cleared this with him.
(And I haven’t been in contact with him for years, which is unfortunate
because he was, and I’m sure still is, a wise and good man from whom I learned
a great deal and would have learned a great deal more had I taken the time to
consider that I didn’t know everything when I was in my late 20s, but I
digress.) It makes no difference,
though, because his name doesn’t matter to, oh, 99% of you and the other 1% know
who I’m talking about.
At any rate, we would have meetings, scheduled or
expedient, in which we would clear deals, and our boss would, of course, have
the final say. As these deals got more
aggressive in the wild and wooly junk bond days of this era defined by the
likes of Michael Milken, Carl Icahn, Saul Steinberg, Nelson Peltz, Frank
Keating, Ted Turner, and a guy nobody trusted named Trump, our boss
had a practice that he engaged in with greater frequency as the deals got more and
more “out there.” He would look over
the red herring (preliminary prospectus), the credit report that I or one of my
colleagues had generated, lean back in his chair, look up toward the ceiling,
and say “We’ve come a long, long way, haven’t we?” We hence were known for doing a lot of deals,
but not nearly as many as most of our competitors. The latter is probably why we consistently
outperformed our junk bond peers in those heady days. And I am being too generous here using the first-person
plural. Most of the credit, no pun intended, was due
to not only to our aforementioned highly experienced boss but also to our
senior portfolio manager, whose name I also can’t use because I haven’t cleared
its use with him, but who remains one of the smartest people I’ve ever known,
and yours truly has known a lot of outrageously smart people; after all, I went
to St. Ignatius (Really, I did, and I graduated…I did.) and spent
most of my career working with, for, and around people on the buy and sell
sides of the investment world. At any
rate, I wonder what my old boss would have said had I proposed a deal featuring
the seemingly now popular “EBITDA add-backs.” He probably would have proposed that
yours truly go a long way…out the door.
Third, when I considered these leveraged loan deals and
hence remember the reaction of my boss to the increasingly aggressive deals we
proposed in the ‘80s, I start musing about the reactions my dad would have had
to some of the suggestions that are now commonplace in today’s “progressive”
society, to wit…
“Hey dad, I’m thinking of doing a semester of study abroad.”
Dad: “Oh, yeah?
“Hey dad, I’m thinking of taking a gap year.”
Two possible reactions:
Dad: “I’ll give
you a gap year…in the meat packing plant,” or
“Better make it a gap decade; you’ll need that much time
to cover the tuition I’ll no longer be covering since you’ll need to cover all
of your living expenses that I’ll no longer be covering.”
“Hey, Dad. I think
God made a mistake and I am really a woman.”
I will add here that I never, ever heard my dad use the
term for which I am substituting %#+*. That is why I believed Mayor Richard
J. Daley, a man of my dad’s generation, geography, and ethnic background,
when he insisted he used the word “faker” when castigating Senator Abraham
Ribicoff at the 1968 Democratic convention, but now I’m off on a
tangent from a tangent.
“Hey, Dad, do you think you might vote Democratic in the
next presidential election?”
Dad: “Is Harry
Truman coming out of retirement (or the grave)?”
“Hey, Dad, do you think you and mom might want to move
somewhere warm when (or, more properly, if you ever) retire?”
Dad: “I’m trying
to lead a reasonably decent life so I can avoid living somewhere really warm
when I, er, retire.”
My dad, too, was a great and wise man.
Fourth (and the only comment that is genuinely germane to
leveraged loans), I suspect that much of the credit difficulty that leveraged
loans are displaying arises from their popularity during a time when investors
were seeking higher yields with at least a feint to the notion of safety along with
protection in what most of those investors perceived to be a rising interest
rate environment. Investors thus eschewed
subordinate, fixed rate junk bonds in favor of senior, variable rate loans. But the relative lack of appetite for junk bonds
resulted in capital structures in which supposedly senior debt lacked the
support further down the capitalization that gives seniority its value. Senior paper is only truly senior when it is
undergirded by generous helpings of subordinated paper. Or at least that’s the way the old timers
used to think. But what do we know?
No comments:
Post a Comment