I originally planned to write something else this week but there was a lot of interest in last week’s broker piece so I thought I would dive a little deeper into some of the issues I didn’t get to address. Namely, if I’m right and brokerage valuations do retrench, what happens to some of these excessively levered brokers?
Short answer: It’s not good. You might want to avert your eyes!
Just the pressure from refinancing debt maturities at higher rates will be enough to stop the music. But even if rates stayed low, there is so little margin of safety in the economic model that any pressure on operating margins becomes tragic.
Once the vise begins to squeeze, the only real way out is to reduce debt…which means selling assets…at bargain valuations. I will show later that may not even be enough.
Setting the Stage
The one big difference between this week and last week’s example is last week I used an example for a hypothetical broker financial model that doesn’t really exist. It was halfway between the public and private brokers in terms of leverage.
This week we’re going straight to a proximate example of a typical highly levered private broker. Thus, we raise debt/EBITDA from last week’s 6X now to 9X (some are even higher). As a result interest coverage drops from near 3X to under 2X.
As you can see below, I then recreated the FCF remaining after paying interest, taxes, and other normal cash uses. The interest paid rises 50% due to the greater debt. I also did add one thing I generously excluded last time which was an estimate for “one timers”.
I made this a 10% drag on EBITDA. We can debate the exact percentage but if you look at adjusted EBITDA vs. EBITDA, even for the public companies, I think you will often find differences > 10% for things such as “restructuring charges”, “acquisition earnouts”, “one time legal fees” and other real cash uses that need to be accounted for.
Thus, between the higher leverage and accounting for one offs, FCF now drops to ~ 1/4 of EBITDA. Note, this squares with rating agency research reports that I don’t have permission to reproduce here.
|Free Cash Flow||Original||New||notes:|
|EBITDA||250||250||$1B rev @25% margin|
|interest||-90||-135||debt now $2.25B vs. prior $1.5B|
|cash tax||-32||-23||20% cash tax rate|
|CAPX||-13||-12||5% of EBITDA|
|other||-25||“non recurring” charges|
|FCF||$115||$55||22% of EBITDA|
Remember, this doesn’t include other uses like dividends, buybacks, or M&A. The dividends are clearly off the table. If the company wants to buy back share creep from equity comp, that will eat up about 1/2 of what’s left leaving precious little for M&A.
But that’s before any external pressures…
The Winds of Change
To be clear, having low available cash generation after paying interest isn’t a death knell. It would be bad for valuations (the original premise) but it wouldn’t cause any financial distress.
What causes financial distress is either rating agency pressure or a widening of credit spreads when it is time to refinance (or both).
Figuring out the rating agency pressure points is easy – it’s debt/EBITDA and interest coverage (EBITDA/interest) metrics. These metrics are already stretched by current levels of leverage.
By the way, if we’re being intellectually honest, interest coverage shouldn’t be to stated EBITDA but to the sustainable level of cash available to the enterprise which means we should subtract the recurring “one time” charges, cash used to buy back stock comp, and the ongoing CAPX.
Those combined are about 1/2 a turn dropping coverage from 1.85X to 1.35X, aka the danger zone. Fortunately, the rating agencies often wear blinders and look through these calculations.
So, what might cause these metrics to fall to unacceptable levels? One of three things – either lower EBITDA, more debt, or higher interest payments.
The one that is the most obvious risk at the moment is higher interest rates. Every 1% increase in average yield reduces FCF by $18M/yr and, more importantly, coverage by ~ .25.
However, we shouldn’t ignore the other risk which is lower EBITDA. Everyone has gotten so used to brokerage margins always increasing but we used to say that about housing prices. There is a high level of complacency by lenders that stable to rising brokerage margins are automatic.
There are plenty of reasons we can come up with for why that may not be true. First, many of these rollups leave their acquisitions alone. It wouldn’t be shocking to see some of these run into trouble over time as principals leave and the successors struggle.
Inflation could certainly pose a problem. Cost structures could easily grow faster than revenue, especially if buyers respond to inflation by buying less coverage to keep premiums flat or demanding more fixed fee relationships. This is what happened back in the 80s/90s.
If you want more of a black swan one, who is to say there isn’t a new technology solution that allows a new provider to be happy with 20% margins and drag down pricing for everyone?
The Spiral Begins
Regardless of whether it is lower EBITDA or higher interest rates, once coverage starts falling, the gig is up and the rating agencies will kick into action.
The first step is one of the agencies goes to a negative watch. This will panic bondholders and credit spreads will gap out (actually, more often the bondholders panic first and the rating agencies belatedly react to the market moves).
This triggers cash preservation mode, meaning M&A stops as do all other growth initiatives like hiring new teams.
Instead, the Treasurer is in charge. Everything is about finding a way to refinance the next maturity (without blowing up coverage further) or raising cash to pay off the debt. Both paths have consequences.
Any higher interest costs on a refinance further reduce the coverage ratio. This means further ratings pressure.
While the natural response might be to sell assets instead to pay off the debt, anything sold lowers EBITDA…and thus both coverage and debt/EBITDA ratios suffer. Of course, once the market knows you have to sell, valuations collapse.
In fact, selling assets may actually make the problem worse. Let’s do some more math. Assume a $30M EBITDA agency was sold for $250M in order to repay a $250M maturity. You can see this actually makes the ratios slightly worse!
|Before Asset Sale||After Asset Sale|
So yeah, that’s a problem. Basically, assets need to be sold at > 9X EBITDA to improve ratios. That may be possible, but it may not in a stressed environment.
Also, remember those numbers are above are from pre-stress. Let’s say EBITDA fell to $225 organically and interest rose to $150 due to higher rates. Now the metrics would be 10X D/E and 1.5X coverage so assets would be need to be sold at 10+ X EBITDA to improve ratios.
If this isn’t possible, what happens? Either you take multi notch downgrades and try to limp forward or you seek to restructure your debt (that’s the nice way of saying default).
Also, remember our chart from last week? The equity holders take all the pain from lower EV valuations. This means a drop from 15X EBITDA to 10X pretty much wipes them out.
That’s a really important point to consider because once the equity value is gone, the PEs don’t have much incentive to worry about what the bondholders get.
Where does this ultimately end up? With a much smaller company sold into pieces to try to avoid bankruptcy. Along the way…
– the equity holders lose everything
– the bondholders take a big loss
– the rating agencies look foolish for allowing so much debt on these towers
– the management is gone replaced by “turnaround artists”
Is any of this a foregone conclusion? No. Is it a risk? Abso-frickin-lutely.
Is this risk priced into the valuation of the private brokerage names today? Not even a little.
Is the risk higher than two or three years ago? Clearly.
So why do brokerage valuations keep going up? Beats me!