Increased Use of "Add-Backs" Can Undermine Risk-Adjusted Returns for Investors in Credit Markets: DDJ Capital
WALTHAM, Mass., Nov. 11, 2014 /PRNewswire/ -- Use of the "add-back," financial slang for an accounting treatment that yields pro forma financial results superior to historical results, is on the rise in financing transactions, posing significant risk to the overall health of the bond and loan markets, according to a new white paper from DDJ Capital Management, LLC, an institutional manager of high yield bond and bank loan strategies on behalf of investors worldwide.
Add-backs may be generated from any number of projected sources, according to the DDJ paper Subtraction by Addition: When More is Less, including achieving possible synergies, discontinuing operations, avoiding one-time costs, modifying accounting practices, and redeeming or equitizing debt. Many add-backs are related to corporate transactions, usually those involving a merger, acquisition, spin-off, or restructuring.
Some add-backs are logical and carry a high probability of realization, while some "we believe are clearly utopian and unachievable," according to Scott McAdam, CFA, portfolio specialist at DDJ and author of the paper.
Since most high yield investors base their yield demands on the level of risk as measured by financial metrics such as leverage and coverage, ratios enhanced by add-backs can influence investors to accept a lower yield than may be appropriate given actual company financial performance, according to the DDJ paper. Ultimately, obtaining this lower yield is the motivation for an issuer to apply add-backs.
Add-backs are a key factor when deciding whether to invest in or reject an issue. When a company comes to market with a new bond or loan deal and conveys earnings that contain add-backs, the quality of those earnings could actually be quite poor, according to the DDJ paper.
Increased use of add-backs comes amid investor demand that is overwhelming the supply of yield-generating credit instruments – and is a sign of deteriorating underwriting standards, according to the DDJ paper.
"Knowing which add-backs may be achievable at a reasonable risk and which may be simply fiction, and what reward to require given the nature of those risks, is a subjective exercise," McAdam said. "Techniques used to value an enterprise should not be adjusted to fit the use of add-backs or other creative issuer strategies intended to lower borrowing costs, but, rather, should remain unchanged with a bias towards challenging any shifts or trends that may permeate the market."
To view the DDJ paper please click here: http://www.ddjcap.com/page/7/news/100/Subtraction_by_Addition_When_More_is_Less_%E2%80%93_How_the_use_of_%E2%80%9Caddbacks_can_undermine_riskadjusted_returns
About DDJ Capital Management, LLC
DDJ Capital Management is an institutional manager of high yield bond and loan strategies based in Waltham, Massachusetts. Established in 1996, DDJ currently manages approximately $8 billion on behalf of corporate and public retirement funds, insurance companies, endowments, foundations and family offices worldwide. DDJ's investment team consists of professionals highly specialized in the areas of credit research, legal analysis, bankruptcy law, portfolio management, trading and business operational improvements. For more information, please visit www.ddjcap.com.
SOURCE DDJ Capital Management, LLC
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