Last week, I wrote a post highlighting increased leverage in private equity deals and the fact that the Federal Reserve was warning of such practices in the piece: Leverage in PE Deals Soars Despite Fed Warnings. In it, I highlighted how 40% of PE deals in 2014 have used leverage ratio above 6x EBITDA, despite Federal Reserve and the Office of the Comptroller of the Currency guidance last year to not breach that ratio.
I noted how ridiculous it is for the institution most responsible for all of the current market insanity to try to come out and talk down leverage ratios. The primary reason all of this craziness is occurring is because the Federal Reserve has intentionally lowered interest rates to such an extent that investors feel they have no choice but to chase the riskiest assets just to catch a few additional basis points. Now we see that junk borrowers are increasingly using tactics such as “add-backs” in order to make earnings look better. This allows low quality borrowers to borrow, while at the same time providing an excuse for investors to buy garbage.
Think I’m exaggerating the problem? According to Bloomberg, 66% of junk-rated bonds sold this year scored by Moody’s Investors Service included at least one adjustment to earnings the credit rater considered “aggressive.” In 2011, the number was just 40%.
Everybody wins right? Wrong. Society will pay a very heavy price for this ultimately.
More from Bloomberg:
Lenders are increasingly allowing junk-rated borrowers to adjust their earnings to make them look more creditworthy as U.S. regulators increase pressure on banks to refrain from underwriting too-risky deals.
Such tweaks, which are permissible under more and more credit agreements, can help companies stay in compliance with their loan terms or to raise debt.
More than half of loans this year for issuers backed by private-equity firms allow them to boost earnings by an unlimited amount through projected cost savings from acquisitions and “any other action contemplated by the borrower,” said Vince Pisano, an analyst at Xtract Research LLC, citing a sample he’s reviewed.
Riskier borrowers may have more incentive to show better financial metrics because the Federal Reserve and the Office of the Comptroller of the Currency are increasing pressure on banks to adhere to underwriting criteria they laid out last year amid concern that the market is getting frothy. Issuers such as Thoma Bravo LLC’s TravelClick Inc. have used adjustments, called add-backs, to raise earnings and decrease leverage when seeking funding.
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