Fed’s Junk-Loan Caution Spurs Creative Accounting Alchemy

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.

With banks trying to fit their deals into the regulatory guidelines, investors have to be more diligent in determining “what is real versus what is accounting” gimmicks, said Beth MacLean, who manages $14 billion in loans at Newport Beach, California-based Pacific Investment Management Co.

Justifiable Increases

Some earnings increases are “very justifiable,” such as savings from actual job cuts, while others can be “very egregious,” she said in a May 14 telephone interview.

Companies that have booked excessive costs have some latitude to reduce those expenses based on projected cost savings.

U.S. regulators have been trying to make banks tighten up their lending standards, with limited success. About 40 percent of this year’s leveraged buyouts had debt of more than six times earnings before interest, taxes, depreciation and amortization, or Ebitda, up from less than 30 percent last year, according to Standard & Poor’s Capital IQ Leveraged Commentary & Data.

The Fed, OCC and Federal Deposit Insurance Corp. said in March 2013 that debt levels of more than six times Ebitda “raises concerns.” Regulators also said that minimum standards should consider a borrower’s ability to repay and “delever to a sustainable level within a reasonable period.”

Deteriorating Standards

Todd Vermilyea, a Fed regulator, said May 13 that standards “have continued to deteriorate in 2014” and that “stronger supervisory action” may be needed.

Loan agreements have “dramatically weakened” and it’s easier than ever for borrowers to boost earnings in more ways than investors may realize, including “extremely speculative” cost savings, said Xtract’s Pisano, who is based in Westport, Connecticut. Those that do cap add-backs limit them to about 25 percent of Ebitda, up from 15 percent a year ago, he said.

About 66 percent 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,” up from 59 percent in 2013 and just 40 percent in 2011. Moody’s didn’t track the same historical data for loan issuers, though speculative-grade companies will often have both loans and bonds.

Selective Accounting

“People don’t pull back the hood of the car and look at the engine on a day-to-day basis,” said Jason Rosiak, head of portfolio management at Newport Beach, California-based Pacific Asset Management, which manages about $4.4 billion. “That is why bankers are able to create selective accounting for each deal.”

Credit Suisse Group AG marketed $560 million of term loans for Thoma Bravo’s $930 million purchase of TravelClick this month with higher earnings after adjustments for both deferred revenue and planned cost savings, according to a person with knowledge of the deal.

TravelClick’s financing was pitched to investors with leverage of 6.6 times, according to another person, who also wasn’t authorized to speak publicly.

Moody’s estimated the debt level at 9.7 times Ebitda, not including those factors, after the private-equity firm’s takeover of the New York-based provider of technology services to the hotel industry. Including deferred revenue, Moody’s calculated leverage of about seven times.

Junk Rating

“TravelClick basically doubled the amount of debt on its books with no increased earnings,” said Peter Trombetta, a Moody’s analyst in New York who rates TravelClick B3, or six levels below investment grade.

Holden Spaht, a managing partner at Thoma Bravo, and Drew Benson, a spokesman for Credit Suisse, declined to comment.

M/A-COM Technology Solutions Holdings Inc., a publicly traded company whose shareholders include Summit Partners LP, signed a $350 million loan agreement this month with no caps on Ebitda adjustments based on cost savings estimated from any action planned within two years, according to Xtract’s Pisano. Goldman Sachs Group Inc. led the financing.

Husrav Billimoria, a spokesperson for Lowell, Massachusetts-based M/A-COM, didn’t immediately respond to a phone call and e-mail seeking comment. Michael DuVally, a spokesman for Goldman, declined to comment.

Cost Synergies

Just because lending agreements allow add-backs doesn’t mean companies will necessarily use them, said Jessica Reiss, an analyst at Moody’s in New York who focuses on covenants and credit agreements. Companies may “ask for the ability to do a lot of different things,” she said.

Deutsche Bank AG led a $202 million first-lien loan this month to help finance Summit Partners’ acquisition of medical technology company Ability Network Inc. Moody’s said in an April 29 report that the takeover would leave the Minneapolis-based company with nine times debt-to-Ebitda “including management’s estimate for acquisition-related cost synergies.”

Mayura Hooper, a spokeswoman for Deutsche Bank, and Joan Miller, a spokeswoman for Summit, declined to comment. Chelle Woolley, a spokeswoman for Ability, didn’t immediately return a phone call seeking comment.

Banks this year have arranged about $257 billion of U.S. loans sold to institutional investors such as mutual funds, compared with a record $695 billion in all of 2013, according to data compiled by Bloomberg.

Borrowers will continue to get flexible terms until banks are unable to sell their deals, Rosiak said.

Investment firms “have to run their own numbers and get back to the basics of credit investing,” he said.

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