'Fake Ebitda' Is Threatening the Integrity of Debt Markets
Ebitda is a popular acronym that stands for "earnings before interest, taxes, depreciation and amortization." It has become a popular metric for measuring a company's financial health, and has seen especially widespread use within private credit markets.
However, its usage has come under fire in recent years. Indeed, it has even become something of a punchline for some credit specialists. For example, in 2017, an anonymous Moody's credit analyst made the now-infamous observation that Ebitda now appears to stand for "Eventually Busted, Interesting Theory, Deeply Aspirational."
While a funny quip, it is no laughing matter.
A poorly defined term
While the theoretical definition of Ebitda is broadly understood and accepted, there is wide variation in how it is defined in practice. Last week, Bloomberg reported on the results of a machine learning analysis of 4,000 public filings. The algorithm found astonishing levels of divergence:
"It took Del Frisco (NASDAQ:DFRG) 2,723 words to explain what Ebitda means, the most of any borrower included in the study. Its definition included 22 types of adjustments it could use to boost its reported earnings. By contrast, blue-chip companies such as chemical giant 3M Inc. (NYSE:MMM) and advertising agency Omnicom Group Inc. (NYSE:OMC) used less than 40 words for their Ebitda definitions. The most concise borrower used 10, barely enough to spell out the acronym. The simpler the definition, the less 'creative' the Ebitda."
There is an obvious reason for such divergence in definitions. Companies seeking debt financing use Ebitda as a proxy for financial health. The more complex the definition and number of caveats a company can employ, the better it can make its Ebitda look.
A deeply compromised metric
The problems with Ebitda go well beyond confusion over definitions. As Bloomberg reported on Dec. 4, Ebitda has been severely compromised as a valuation metric within credit markets:
"Some companies and their private-equity owners are goosing projections and presenting assumptions about returns that are more aggressive than their own internal models...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."
Massaging, or outright faking, of Ebitda metrics has reached epidemic proportions within the private equity industry, according to Alan Waxman, a respected credit market maven. Things have gotten so out of hand that Waxman fears it may end up threatening the very integrity of private capital markets if left unchecked.
A litany of victims
Lenders are the most obvious actors to suffer when a market becomes rife with fake Ebitda metrics. Fake Ebitda threatens lenders' ability to accurately assess credit-worthiness and default risk.
Of course, lenders are not the only ones being victimized. As one denizen of financial Twitter observed this month, allocators and limited partners are also victims in the drama:
"PE Funds have convinced lenders that 'Fake EBITDA' numbers justify huge loads of debt. They have also convinced LPs that those Fake EBITDA numbers mean they are paying reasonable valuation multiples."
The increasingly widespread abuse of Ebitda can actually be useful to eagle-eyed investors. Indeed, it increasingly serves as a proxy for true financial health and managerial probity. While Del Frisco's offers a clear example of slippery definitions, that of 3M Co. shows a welcome degree of transparency. That should be a clue as to which company's debt load is more sustainable.
Verdict
A debt market based on fake metrics cannot remain stable indefinitely. Eventually, something will give. What the catalyst will be remains unclear, but fantasy metrics cannot stand on their own forever. Moreover, the eventual fallout is unlikely to be limited to private debt markets. With corporate debt stretching into publicly traded companies as well, fake Ebitda may prove a problem for many indebted public companies.
Investors should be paying close attention to debt markets, especially the private debt market that has been fueled by private equity firms' increasing willingness to massage their Ebitda figures. When something so unsustainable is so easily observable, it pays to be prepared.
Disclosure: No positions.
Read more here:
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
This article first appeared on GuruFocus.
