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An Echo of 2007? Let’s Hope This Time Is Different

Oliver Schutzmann, CEO  |  21 June 2020

Debt and EBITDAC

Two stories emerging last week provide more evidence of extraordinary times in the markets.

We are less than half-way through 2020, but US companies have issued more debt via the corporate bond market than in the whole of last year.  The 2019 total of $1.15 trillion was surpassed last week, and 2020 is on course to break the record for the largest amount ever raised in the debt markets. The news comes on the back of the all-time record issuance for a month in April, followed by the second and third largest in May and March. Investor appetite for corporate paper shows no sign of waning, even as the returns they can expect decline.

In part, this is due to government action: The Fed kicked off a programme to buy corporate bonds on Tuesday, stepping in to buy individual bonds for the first time. But the suspicion is that this action has led to companies trying to opportunistically lock in historically low borrowing costs rather than shoring up balance sheets to survive the crisis.

Whatever the reason, the net result is the same: a mountain of debt on top of already high corporate borrowing levels which will, some day, have to be repaid. The presence of Uncle Sam on the buyside, however, serves to reassure all investors, and to give comfort to issuers.

A second development last week was more extreme, and perhaps more worrying.

Media reported that a German manufacturing company, Schenck Process, presented a new metric in its earnings announcement: EBITDAC.

We have been familiar with EBITDA – Earnings Before Interest, Tax, Depreciation and Amortisation – for 20 years or more. The ‘c’ in EBITDAC is a new element, however. It stands for “Coronavirus”.

Schenck Process is asking analysts and investors to assume the pandemic never happened, and to add back the earnings lost because of it. Just as EBITDA serves to provide a guide to valuation by focusing on cash profits, so EBITDAC is said to be a guide for the market to the underlying value of a firm that has been hit by pandemic-related revenue loss. If it weren’t for the pandemic, we would have made x instead of the y that we are actually reporting.

The problem with this approach is that while depreciation and amortisation are ‘artificial’ accounting procedures that impact the bottom line, revenue attrition because of a pandemic is very, very real. Will Schenck Process see these revenues return post-pandemic? Nobody knows. Will the world return to normality with no impact on earnings? Unlikely. Should a company therefore ask investors to turn a blind eye to losses caused by a global health crisis? Of course not.

The technique is alarming for another reason: assuming EBITDAC starts to be used more widely for valuation and cash flow forecasting, the picture of corporate health that it paints will see borrowing costs fall further as debt investors are given a more positive outlook than actually is the case. In the short term, it means that companies can survive by borrowing. Longer term, it serves only to store up credit default issues for the future.

Apart from the corporates gorging on cheap debt, who is benefitting from these trends?

Schenck Process is owned by Blackstone, a large US alternative investor with $538 billion in assets under management. By inflating the value of one of its portfolio companies, Blackstone is able to report more positive returns.

On the corporate debt side, Debt Capital Market (DCM) underwriting fees surpassed $10bn during the first quarter for the first time since records began, a 13 percent year-on-year increase, according to Refinitiv. So DCM desks in large banks have made fat fees by encouraging their clients to take advantage of the Fed’s policy move.

Banks and Private Equity are the most obvious winners, then. Which begs the question: Haven’t we been here before? Opaque debt structures masking corporate underperformance; banks encouraging a herd mentality to generate fees; politicians and policymakers being blindsided by financial wizardry; debt investors not understanding what they are buying. It all sounds rather too much like 2007 for comfort. And we know how that ended.

The circumstances are different now to the build up to the great financial crisis, of course: banks are better capitalised; disclosures better regulated; markets (allegedly) are better policed; and policymakers more wary.

But the sheer scale of the debt being built up by governments and corporates is of a new magnitude. In many ways, it is not that “This time is different”; it is that “We have never been here before”.