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Private Credit 

Chris Haffenden

I used to view myself as a hack accountant, or should that be a hack who at times wished he was a qualified accountant? To burn through the financials fog, I heavily relied on my excellent analyst team at Debtwire —  with special belated thanks to Nick Smith Saville — to see clearly on complex sits, most notably Croatia’s Agrokor in 2017, the largest European fraud since Parmalat. 

I’ve had some formal training since, most notably via Grant Thornton on my Exec MBA (82% in the exam 😀) and Financial Edge, which ran an excellent course for all 9fin-ners last year. 

This followed years of fumbling around with numbers. Possessing a journalist’s healthy skepticism, I’ve always sought to find how companies massage their numbers and what the accounts are really saying (or hiding). I would strongly recommend Financial Shenanigans by Howard Schilt as research material here for budding journos and analysts — it may be 25-years old, but he keeps updating the book with the latest frauds. 

One of the accounting concepts I’ve struggled the most with over the years is goodwill. 

I get that its the premium paid for a business and must be included as a balancing item on the balance sheet as an intangible asset, and brands, management teams, etc can have some value. 

But surely, like depreciation it should be amortised — rather than kept at the same level forever? Should it be separated from other intangible assets such as brands? 

As KPMG and the global IFRS institute outlined in 2020 the IASB had published a discussion paper on the topic whose starting point was “to consider whether a more effective goodwill impairment test would provide a timely signal about an acquisition’s performance – for example, by testing goodwill impairment directly (the current impairment model tests goodwill indirectly – the unit of account is the CGU”.

Proponents of amortisation see this as a simple mechanism for reducing the risk of overstating goodwill, whereas others suggest it is not a wasting asset with a finite useful life. Either way, in my view there should be stricter rules around impairment tests. 

This is one of the hottest debates within the accounting world, and it looked like points of authority, such as the Financial Accounting Standards Board, were one step closer after crawling in their skin this way for a number of years. But in the end, last July, the FASB walked away from four-years of work, after intensive lobbying from the SEC and investor groups. 

There is $4trn of Goodwill on US company balance sheets and, according to Bloomberg analysis last year, the FASB proposals would have reduced book value of the S&P 500 by more than a third in 2022 — while pushing IBM and PepsiCo into negative equity!

But is inflating asset values via goodwill one of the greatest financial crimes?

But its use in calculations for asset-heavy businesses can give investors a false sense of comfort — for example, goodwill makes up 43% of Merlin Entertainments total assets. 

If goodwill is further added into credit metrics and covenants, it takes this to another level. It could even prove to be problematic and erode investor protections. 

We’ve noticed the inclusion of goodwill in some of the racier accounting treatments of LTV in Real Estate businesses, such as Aggregate Holdings’ subsidiary VIC Properties, recently soft-restructured Accentro and the latest RE accounting problem-child, Sweden’s SBB. 

Surely, with property companies we just need to look at hard asset coverage rather than intangible? After all, it’s not that complicated and the intangibles are few, with most real estate lending done at the asset rather than corporate level. Typically bank lenders will not lend at more than 50% LTVs and many HY borrowers have covenant trips in the 60s, so there is plenty of incentive to find accounting methods to dampen down LTVs. 

Other LTV shenanigans include how development asset values are booked, as many use the higher net realised value (NRV) — the amount rather than the cost. We also have the wonderful percentage of completion method to boost revenue assumptions further. 

Batting this around on Thursday with some of the 9fin analysts (thanks Emmet and Hazik), we concluded that neither would reflect fair value as you would hope to sell assets for more than what they cost. But in a big downturn, you may have to mark down net realisable value, in which case you should have already impaired goodwill too. 

It should be contentious if you are booking assets at NRV much higher than accumulated cost AND you're carrying goodwill for those same assets. If buying partly developed assets, it is more nuanced as initially you will book as inventory at accumulated cost incurred by the seller plus whatever premium you pay as goodwill, notes Emmet McNally. 

As outlined in Hazik Siddiqui’s excellent Stressed QuickTake for SBB there have been a number of tweaks to its LTV calculations that could be viewed as contentious (see our table below):

We decided to use the LTV definitions prescribed by the European Public Real Estate Association (EPRA) to get to a more representative figure. We have included the hybrid debt instruments in the calculation (more on this asset class later) as they are trading in the high teens (price, not yield!) and as such they have little prospect of being called and therefore should be fully treated as debt, which gets us to a lofty 66% LTV figure rather than 49%. 

But LTV is arguably not the most pressing issue for SBB right now, as it is in consolidation mode. 

As Hazik outlines, amid credit rating downgrades, the loss of access to commercial paper and some secured credit lines, refinancing its sizeable short-term unsecured debt maturities is extremely difficult, and even if it it is still possible to do so, it will be at much higher interest rates, sharply reducing interest cover and threatens a breach of maintenance covenants. 

That might have already happened, however. Following its most recent earnings release, 9fin understands that lawyers Cleary Gottlieb on behalf of a group unspecified EMTN holders sent a letter to the company in late May claiming a breach of its consolidated coverage covenant. The company promptly denied this, issuing a statement that it still meets the covenant as at Q1 23. 

We were typing up our source notes and trying to make the calculation ourselves when S&P Global Ratings, in a savage two-notch downgrade and damming commentary, shone a spotlight (or should that be a searchlight) on this contentious issue. 

The ratings agency said (the bolding is our emphasis):

SBB moved the “result from associated companies/joint ventures” below a newly introduced line of “operating profit” and, hence, changed the presentation and level of disclosure on its profit and loss statement, which is the basis for the covenant calculation. While the company confirmed via press release that it believes it is compliant with its covenants, we view the changes in accounting as weakening transparency, and introducing inconsistency and ambiguity on the interpretation of financial statements at a potentially transformative moment for the company.

In addition, the company has not presented a clear restatement of its accounting changes in the updated first-quarter report, published May 29, 2023, compared with the first-quarter financial report published April 29, 2023, because the latter is no longer available at the company’s website. This validates our view of the company’s limited transparency and track record in executing its deleveraging path, the latter having been hindered on occasion by unexpected events.

Luckily, the removed report is still on 9fin’s website because we upload all the docs as they are posted and don’t rely on website links. We will do our own calculations, so watch this space. 

Despite the company’s protestations that it is in compliance, we wouldn’t be surprised if some holders might decide to go legal.

And there is an interesting twist, which might encourage them to do so. 

SBB’s EMTN bonds have no percentage requirement to call a default. This is rare — you might say this is for obvious reasons, but it has been seen in a few IG issues according to our legal team —  and it also crops up in Demire, the German RE company. In most cases you have a trustee (not in SBB) with a threshold, typically 25-30%, to instruct. 

The lack of threshold and lack of a trustee means holders can act on their own and pursue repayment in the English courts, as the bonds are under English Law. But as one lawyer mentioned to us, this raises a prisoner’s dilemma — if each individual bondholder is incentivised to pursue recovery individually, as it might be the best outcome for them — but if everyone does it, SBB potentially faces a major issue and a messy collapse. 

It’s been quite a few weeks for SBB. It reminds me of Ernest Hemingway in The Sun Also Rises who was asked — how did you go bankrupt? 

“Two ways. Gradually, then suddenly.”

SBB was struggling to maintain its investment grade ratings for almost three years, mostly using a series of hard to follow deals and joint ventures, and what we are interested about in this section of the Workout, by issuing a shedload of hybrid bonds — SEK 19.5bn (€1.67bn) between 2019 and 2021 — mostly to refinance existing debt. But its credit rating has plummeted from BBB- less than a month ago to just BB- after the two-notch papercut from S&P on Wednesday. 

Hybrids are a creature of the zero interest-rate environment, and we’ve seen plenty of cheerleaders for this asset class in recent years. 

They are a ideal instrument for a corporate treasurer, very long-dated debt which is treated as quasi-equity, with no pesky voting rights and the ability to miss coupon payments without triggering a cross-default. Admittedly, there is a dividend blocker if coupons are not paid.

For investors it gives a nice yield pick-up (normally rated two-to-three notches below) and surely the borrowers would redeem at their first call date in five-to-seven years from issue, as coupons step-up and revert to a margin at a floating rate? In addition, ratings agencies get angsty, with S&P treating as 100% debt (typically 50:50 before) if they choose not to call. 

But in a rising yield environment, the game changes. 

Suddenly, corporate treasurers are motivated to keep them in place, and not call, nor refinance. Not a problem for highly-rated frequent borrowers such as EDF and VW. But it is for (former) investment grade Real Estate businesses such as AroundTown (which failed to call in January) and the our favourite Swedish fallen angel SBB, whose businesses are more sensitive to rates, and are more likely to suffer from papercuts and in the end are just one step closer to the edge and a downgrade to junk. 

Hybrids are much higher beta instruments (credit and interest rates) and in my view are over-hyped and their risks misunderstood. They are really just equity with a coupon — but with no equity upside, no voting rights — and unlikely to get much in a liquidation scenario with virtually no triggers. 

Similar to AT1s in financials, do holders really understand the risk/reward here? When did you last hear hybrid debt was the fulcrum security and their holders made out like bandits?

Remember, these instruments are not new. I can remember the carnage for the fledgling hybrids market caused in 2014 by KPN, the Dutch telco, when it failed to call its hybrids, leaving investors in a BBB- rated borrower on negative watch with 2073 paper and paying barely a coupon! They were warned, as the FT reported at the time quoting the CFO that they would have been downgraded to junk at the time if they hadn’t done the hybrids alongside the equity issue. 

But most EHY analysts were still in school then, so this has been forgotten. As one of my newer colleagues told me at the back end of last week, several HY investors are telling him that they prefer hybrids from IG/crossover credits to high yield, given the paucity of yields on offer in EHY. 

Scope Ratings in January, were certainly bullish on the sector, but the agency might be talking its own book, given its elevated presence in this niche finance sector. But it's worth noting that €50bn of calls are due this year and next, so it might only take an unexpected decision or two to cause a blowout in spreads, pushing investors away.

In the end, if you want to juice returns, don’t take deeply subordinated utilities paper — not really a sector for EHY analysts after all, it’s almost zero weight in the index — although 9fin’s Denitsa Stoyanova was a utilities analyst in a past life. For these companies it is all about trying to maintain your optimal rating, which is around triple B minus, but it can be a difficult balancing act, as some might need to maintain an investment grade rating for regulatory purposes. 

For many unregulated issuers, hybrids deals should be seen as a warning not an opportunity. It often presages an upcoming downgrade to junk, most famously Telecom Italia in 2013, and it still hasn’t crawled back to investment grade. 

For those looking for a cure for the hybrid itch, and runaway returns, why not apply a couple of turns of leverage instead to a debt tranche in a decent BB EHY name? Or for those who like some equity upside for those with tradable equity, buying a convert in the same debt stack close(ish) to being in-the-money will do nicely. At least if it goes wrong, you rank alongside the rest of the debt stack, and have the same documentary protections as the pari passu HY bonds. 

Anyway, that’s my hybrid theory, and having those words in mind gave me impetus to play Linkin Park at full volume, providing a good place for my head, being by myself and not with you, when writing this. 

Yesterday’s early morning walk along the Thames path, seeking inspiration for the Workout, was enlivened by Jim Grant, from Grant’s interest rate observer in a highly entertaining and educational Odd Lots podcast. Aside from Cloud9fin, this is the must listen pod for this week. 

I’ve read Grants since I was a young trader in the early 90s. That was a time when, as Jim notes, interest rates were definitely worth observing. The pod has so much to credit it for, his section on financialisation of markets and private credit — ”the same old wine in a prettier bottle” — is great. 

I also liked his thoughts on Nvidia, and the comparisons to Sun Microsystems in the internet bubble. Both were seen as the main beneficiaries of their respective transformational booms, the greatest leap since the discovery of fire. 

“Now thats a big total addressable market,” says Grant. 

Nvidia is trading at 35 times its revenues — yes revenues, not earnings — and 15x its juiced-up FY 27 earnings. In comparison, Sun Microsystem’s maxed out at a mere 10x earnings. 

Jim reminded me of Sun’s CEO Scott McNealy’s quotes a couple of years later after Sun’s bubble burst (hat tip Jessie Felder) 

Fast forward just a few years, and I give you private equity and directories businesses, as next up. 

For the young EHY analyst readers, if you wanted to find someone’s contact details or find a plumber in the noughties, you probably still had to use one of these:

Private Equity buyers were paying mid-to-high teen multiples, the highest across EHY thinking that the move to digital would reduce costs massively and be easier to build scale. 

But less than five-years later most deals had gone bad, including those for European Directories, Yell (yellow pages) Seat PG, and its French-equivalent Pages Jaunes which we will concentrate on further here. To turn a page (pun intended) they all changed their names to Truvo, Hibu, and Solocal, hoping that investors wouldn’t locate their restructuring history, under P for painful. 

In 2011, Page Jaunes was seen as the best of a bad bunch, I dug out this gem from Fitch on its senior secured notes issuance at the time “suggesting limited execution risk in the transition from print to internet.” It added, “Distress or default would be caused by a further reduction in EBITDA to a post-restructuring EBITDA level of EUR450m.” 

10 years later its management would byte your hand off for even 50% of that number, with adjusted EBITDA plateauing at around €120m in the past couple of years. Two restructurings have reduced the debt to around €450m (from €1.7bn at the time of its buyout in 2006). And this week Solocal raised the likelihood of yet another, by entering into mandat ad hoc proceedings. 

So, what are the next former Private Equity darlings to go Ex-Directory?

Software and Healthcare are top of my list. Unfortunately, they are the two sectors which direct lenders are most exposed to. 

The outcome of Finastra’s push for a jumbo PIK from direct lenders to refinance its highly-leveraged debt stack will be closely watched as evidence of continued appetite for software biz. To me it feels a stretch, and a last ditch gamble to avoid a restructuring. Without irony, it is worth noting that Finastra derives almost all its revenues from financial institutions, so the long-awaited consolidation of US regional banks won’t help here. I also note, that projected interest cover (before the new refi) is a mere 1x. 

What we are (re)reading/watching this week

Apologies for the lack of an in-brief section, I got a little carried away with the above, and ran out of room. 

This week provided some respite from the deluge of earnings reports, and HY issuance despite a number of pinks and early-birds out there, was limited to just Infopro. 

This provided more time to read and even re(read) some excellent commentaries from my colleagues. Owen Sanderson’s Excess Spread this week finds a silver lining in a CCC storm for CLOs — as most have either defaulted or entered into processes, Diebold, GenesisCare and Casino, or are making last ditch attempts at distressed A&Es such as Hotelbeds, Finastra (see above) and Keter. There is a hollowing-out of CCC buckets. 

Speaking of CCCs, we are doing a lot more work on CLOs, their investments, mechanisms, protections and triggers, most notably at the bottom end of the credit spectrum. Watch out for a piece or two in the coming days — my working title is The Bucket List. 

Yet more pressure is being applied on hedge funds and their behaviour in Sovereign debt restructurings. A great piece in the FT from Daniel Reichert-Facilides, Senior Partner at Chatham Partners highlights that safe harbour laws have passed the New York State Assembly in May.

I assume that this tweet, must be surely referring to the German RE market:

Yet more bad news for those on the receiving end of creditor on creditor violence. Serta Simmons Bedding’s (SSB) Plan of Reorganisation was approved this week, ending three years of litigation from aggrieved former lenders with Judge Jones saying that evidence of SSB’s good faith was overwhelming — for more see the victorious legal counsel’s summary here

The youth of today, are so more tech savvy than me (hat tip Sam Stevens). Excel with Dummies.

And finally, a top incoming lead — still to be double-sourced by our crack restructuring team

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