Monday, August 06, 2007

The origins of EBITDA and its implications

Ever wonder how did the term EBITDA – Earnings before Interest, Taxes, Depreciation and Amortization – come about? This goes back to more than half a century back with the beginning of Zero-Coupon bonds.

The first zero-coupon bonds – the famous Series E U.S Saving Bonds – were sold during World War II. No one then called the Series E a zero-coupon bond then, a term probably not invented yet. But that’s precisely how Series E functions.

These bonds came in denomination as small as $18.75. That amount purchased a $25 obligation of the U.S. government due in 10 years, terms that gave the buyer a compounded annual return of 2.9%. At the time, it was an attractive rate. That means the buyer would pay $18.75 for every $25 bond that the government issued. There’ll not be any yearly or semi-yearly interest given. Only at the end of 10 years, would the buyer get his $25. In effect, a zero-coupon bond requires no current interest payments from debt obligators, the investor receives his yield by purchasing the security at a significant discount from the maturity value. The effective interest rate is determined by the original issue price, the maturity value, and the period between issuance and maturity.

However, Saving Bonds are only issued to individuals and are unavailable in large denominations. One problem with a normal bond is that even though it pays a given interest rate – say 10% - the holder cannot be assured that a compounded 10% return will be realized. For that rate to materialize, each annual coupon must be reinvested at 10% as it is received. If the current interest rate is, say, 7% when these coupons come due, the holder will be unable to compound his money over the life of the bond at the advertised rate. For pension funds or other investors with long-term liabilities, “reinvestment risk” of this type can be a serious problem. And thus, Saving Bonds of Series E type can solve it. What big players needed was huge quantity of “Savings Bond Equivalent.”

Enter some ingenious – in the early 1980s – in this case, and you guess it, some investment bankers again. They created the instrument desired by “stripping” the semi-annual coupons from the standard Government issues. Each coupon, once detached, takes on the essential character of a Savings Bond since it represents a single sum due sometime in the future. For example, if you strip the 40 semi-annual coupons from a U.S. Government bond due in 20 years, you will have 40 zero-coupon bonds, with maturity ranging from 6 months to 20 years, each of which can then be bundled with other coupons of like maturity and marketed. If current interest rate is 10%, then a 20-year issue will sell for 14.20% of each dollar of bond. The purchaser of any given maturity is thus guaranteed a compounded rate of 10% for his entire holding period. As the years went by, stripping of government bonds is done on a large scale as it is well suited to the big buyers’ needs.

But all too often on Wall Street, what the wise men do in the beginning, fools do in the end. In the late 1980s, zero-coupon bonds and their functional equivalent, pay-in-kind (PIK) bonds have been issued in abundance by ever-junkier credits. (PIK bonds distribute additional PIK bonds semi-annually as interest instead of paying cash.) To these issuers, zero or PIK bonds offer one overwhelming advantage: It is impossible to default on a promise to pay nothing.

This principle at work – that you need not default for a long time if you solemnly promise to pay nothing for a long time – has not been lost on promoters and investment bankers seeking to finance ever-shakier deals. But its acceptance by lenders took a while. When the leveraged buy-out craze began in the mid 1980s, purchasers could borrow only on a reasonably sound basis, in which conservatively-estimated free cash flow was adequate to cover both interest and modest reductions in debt.

In the late 1980s, as the adrenalin of deal-makers surged, businesses began to be purchased at prices so high that all free cash flow had to be allocated to the payment of interest. That left nothing for the pay down of debt. Debt now became something to be refinanced rather than repaid.

Soon borrowers found even the new, lax standards intolerably binding. To induce lenders to finance even sillier deals, they introduced an abomination, EBITDA, as a test of a company’s ability to pay interest. Using this yardstick, the borrower ignored depreciation as an expense on the theory that it did not require a current cash outlay.

Such an attitude surely is delusional. Capital expenditures that roughly approximate depreciation are a necessity and are every bit as real an expense as labor or utility costs. Even a high school dropout knows that to finance a car he must have income that covers not only interest and operating expenses, but also realistically calculated depreciation. He would be laughed out of the bank if he started talking about EBITDA.

Capital outlays at a business can be skipped, of course, in any given month, just as human can skip a day or two of eating. But if the skipping becomes routine and is not made up, the body weakens and eventually dies. Furthermore, a start-stop feeding program will over time produce a less healthy organism, human or corporate, than that produced by a steady diet. But of course, as businessmen, you should relish having competitors who are unable to fund capital expenditures.

You might think that waving away a major expense such as depreciation in an attempt to make a terrible deal look like a good one hits the limits of Wall Street’s ingenuity. If so, you haven’t read enough on the behavior of Wall Street. Promoters needed to find a way to justify even pricier acquisitions. Otherwise, they risked losing deals to other promoters who are more “imaginative.”

Promoters and their investment bankers proclaimed that EBITDA should now be measured against cash interest only, which meant that interest accruing on zero-coupon or PIK bonds could be ignored when the financial feasibility of a transaction was being assessed. This approach not only relegated depreciation expense to the let’s-ignore-it corner, but gave similar treatment to what was usually a significant portion of interest expense. To their shame, many professional investment managers went along with this shenanigans, though they usually were careful to do so with only clients’ money, not their own. Calling these managers “professionals” is actually too kind, they should be designated “promotees.”)

Under this new standard, a business earning, say, $100 million pre-tax and having debt on which $90 million of interest must be paid currently, might use zero-coupon or PIK issue to incur another $60 million of annual interest that would accrue and compound but not come due for some years. The rate for these issues would typically be very high, which means that the situation in year 2 might be $90 million cash interest plus $69 million accrued interest, and so on as the compounding proceeds. Such high-rate reborrowing schemes, which in the early 80s were confined, soon became models of modern finance at virtually all major investment banking houses.

Investment bankers show their humorous side when they make these offerings: They dispense income and balance sheet projections extending five or more years into the future for companies they barely had heard of a few months earlier.

Ken Galbraith, an influential Keynesian economist, in this witty and insightful bestseller, The Great Crash, coined a new economic term, “the bezzle,” defined as the current amount of undiscovered embezzlement. This financial creature has a magical quality: The embezzlers are richer by the amount of the bezzle, while the embezzlees do not yet feel poorer.

Professor Galbraith astutely pointed out that this sum should be added to the National Wealth so that we might know the Psychic National Wealth. Logically, a society that wanted to feel enormously prosperous would both encourage its citizens to embezzle and try not to detect the crime. By this means, “wealth” would balloon though not an ounce of productive work had been done.

The contemptuous nonsense of the bezzle is dwarfed by the real world nonsense of the zero-coupon bond. With zeros, one party to a contract can experience “income” without his opposite experiencing the pain of “expenditure.” In the earlier example, a company capable of earning only $100 million dollars annually – and therefore capable of paying only that much in interest – magically creates “earnings” for bondholders of $150 million. As long as major investors are willing to don their Peter Pan wings and repeated say “I believe,” there’s no limit as to how much “income” can be created by the zero-coupon bond.

Wall Street understandably welcomed this invention. Here, finally, was an instrument that would allow the Street to make deals at prices no longer limited by actual earning power. The result, obviously, would be more transactions: Silly prices will always attract sellers. But as intelligent investors watching from a distance, the more unprudent the market is, the more prudence you should exercise your own doings.

The zero-coupon or PIK bond possesses one additional attraction for the promoter and investment banker, which is the time eclipsing between folly and failure can be stretched out. This is no small benefit. If the period before all costs must be faced is long, promoters can create a string of foolish deals – and take in lots of fees – before any chicken come home to roost from their earlier ventures.

But, in the end, alchemy, whether it is metallurgical or financial, fails. A base business can not be transformed into a golden business by tricks of accounting or capital structure. You can smoke your way through but you can not gain knowledge. The man claiming to be a financial alchemist may become rich. But naïve investors rather than business achievements will usually be the source of his wealth.

Whatever their weaknesses, many zero-coupons or PIK bonds will not default. No financial instruments are evil per se; it’s just that some variations have far more potential for mischief than others.

The blue ribbon for mischief-creating should go to the zero-coupon issuer who is unable to make its interest payments on a current basis. An advice ought to be heeded is: whenever an investment banker or rather promoter starts talking about EBITDA or whenever someone creates a capital structure that does not allow all interest, both payable and accrued, to be comfortably met out of current cash flow net of ample capital expenditures – shut your wallet tight. Turn the tables by suggesting the promoter and his high-priced entourage accept zero-coupon fees, deferring their take until the zero-coupon bonds have been paid in full. See then how much enthusiasm for the deal endures

The comments here about investment bankers may seem harsh but I believe that they should perform a gatekeeping role, just as auditors rightfully should but, guarding investors against the promoter’s propensity to indulge in excess. Promoters, after all, have throughout time exercised the same judgment and restraint in accepting money that alcoholics have exercised in accepting liquor. At the least, the banker’s conduct should rise to that of a responsible bartender who, when necessary, refuses the profit from the next drink to avoid sending a drunkard out on the highway. Unfortunately, many on Wall Street have found bartender morality to be an intolerably restrictive standard. Once, those who travel the low road on Wall Street encounter heavy traffic, everything comes to a standstill.

One distressing note: You may think the cost of zero-coupon folly will only be borne by the direct participants but that is far from the truth. Many pension funds, institutional investors were heavy buyers of such bonds, using cash. Straining to show splendid earnings, these buyers recorded – but did not receive – ultra-high interest income on these issues. Many of such funds got into big problems. Had their loans to shaky credits worked, the owners of the funds would have pocketed the profits. In many cases in which the loans will fail, the taxpayer will pick up the bill.


musicwhiz said...

Hi berkshireh,

Good write-up on zero-coupon bonds though a little cheem to read hehe. Keep up the postings ! Good work !

fishman said...
This comment has been removed by the author.

IBITDA is an important metric but its not everything.