"EV coverage" theses are lazy and a pet peeve of mine
I work in credit and see a lot of people (and colleagues, unfortunately) saying that they are comfortable buying paper at (for example) 80, because at 80 "you are creating 6.5x" leverage or whatever.
I think in many cases it is a very lazy thesis. It is what a bad analyst thinks a good analyst sounds like. Few reasons below. What do you think?
- What about duration?
- What is the actual catalyst? Who will take you out at the EV you think it's the right one?
- What happens if your 80 "creates" 6.5x leverage in Q1, but in Q3, after terrible numbers, your 80 created what is now 7.5x?
- You can be below EV and still get badly hurt.
- In a restructuring, you backsolve the cap stack to make the cash flows work, not looking at where EV is (in most cases).
- Are you comfortable owning the business to flip it for your EV target?
Based on the most helpful WSO content, your skepticism towards the "EV coverage" thesis in credit analysis is well-founded and highlights a critical perspective that many professionals in the field share. Let's dive into the points you've raised:
Duration: Absolutely, duration is a critical factor often overlooked in the EV coverage thesis. The time value of money and the holding period risk significantly impact the investment's return profile. Duration affects the sensitivity of a bond's price to changes in interest rates, which can materially impact the investment's value over time.
Actual Catalyst: Identifying a credible catalyst is essential for any investment thesis. Without a clear understanding of what will drive the revaluation of the debt to the targeted exit price, the investment is speculative at best. The question of who will buy the debt at the anticipated enterprise value (EV) and why is crucial for validating the investment's exit strategy.
Changing Leverage Ratios: Your point about leverage ratios changing with business performance is spot on. An investment that looks attractive at 6.5x leverage can quickly become less so if the company's performance deteriorates, pushing the leverage to 7.5x. This highlights the risk of relying too heavily on static metrics in a dynamic business environment.
Risks Below EV: Being below the EV does not shield an investor from losses, especially in scenarios where the company's operational performance declines or market conditions worsen. The safety margin can erode quickly, leaving investors exposed.
Restructuring Dynamics: In a restructuring scenario, the focus shifts towards making the capital structure sustainable by aligning it with the company's cash flow generation capacity, rather than targeting a specific EV. This process often involves significant adjustments to the debt levels, interest rates, and sometimes even debt-to-equity conversions.
Ownership Comfort: The willingness to own the business at the calculated EV is a critical test of the investment thesis's robustness. If the investor is not comfortable owning the business at the assumed valuation, it raises questions about the validity of the investment rationale.
Your critique underscores the importance of a comprehensive and dynamic approach to credit analysis, beyond simplistic EV coverage metrics. It's a reminder that good analysts dig deeper, considering a range of factors and scenarios to assess an investment's true risk and potential.
Sources: Eight Habits of Top Bucket IBD Summers, A Contrarian View - Raging Bull, Creating own LBO assumptions, Private Credit Resources and Prep, A Cover Letter Template for Investment Banking
Agreed. Is this the same / similar concept as the "equity cushion" in credit analysis? If so, have been scratching my head on how that made sense for a while now and glad to read somebody had the same reasoning
The only time I’ve ever used creation multiples are when a company is actually in restructuring, with an RSA/DS on the docket, or an exchange offer is on the table and you need to figure out where the market is pricing the deal. All other instances are silly and 9/10 times I hear this it’s from bucket shops pitching some trash. It’s almost as bad as when analysts say a bond at 6x is covered because comps trade at 10x without looking at any differences in business quality or cash flows.
Definitely lazy, same thing as buying/shorting something purely for the rating rel val...
Here are my favs:
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