If you take a look at my personal investment recommendations, you might notice a lot of the companies I target have “bad balance sheets” as some would define it. Why do I target these companies?
- The Equity market clearly overreacts to companies with bad balance sheets (which provides opportunity to nab good businesses that can support higher leverage)
- Patience is rewarded
- I think how people measure bad balance sheets is too simplistic
- As the company pays down debt, every dollar of debt paid down is a dollar gained to the equity
It may be best to walk through a few examples. And to be clear, in most cases, I am discussing names that don’t have near-term maturity issues as it is hard to bank on the capital markets always being open. That is my one important disclaimer.
The company I will be discussing today is Platform Specialty Products (now called Element Solutions), a specialty chemical company that originated as a SPAC formed by Martin Franklin. Franklin is a serial deal maker, known for a strong track record at Jarden where he conducted dozens (maybe even hundreds) of bolt-on acquisitions. According to Fortune, Jarden’s 10 yr annualized return was 17.9%. Not too shabby.
Anyway, Franklin’s strategy with Platform was to buy “Asset light, high tough” business. That is, those with limited capital intensity, but high margins because of the service the businesses provided to its customers. This alone would tell you the businesses he was targeting have high barriers given the margins plus service component that is hard to replicate. Platform would also carry a “high” leverage amount — around 4.5x EBITDA — but if you assumed the companies were worth 12.0x together, it wasn’t that big on a debt-to-cap basis.
That’s a problem with how people view bad balance sheets – you cannot look at leverage in a vacuum. 4.5x leverage on an auto supplier is much different than 4.5x leverage on a sticky, recurring, non-cyclical business.
Long story short, after a series of frenzied acquisitions (mostly funded via debt), Platform got over its skis. Fundamentals for its Agriculture chemicals business got burned by the Brazil real devaluation, and the company was 7.0x levered. The stock fell from $28 to slightly below $6, valuing the company at ~8.0x EBITDA (when comps were trading at double-digits), plus a high-teens FCF yield to equity, and a portfolio of strong businesses.
The headlines and chatter at the time were ridiculous. The company’s nearest maturity was >5 years out and people were concerned about Platform tripping a covenant (it had no covenants other than on its revolver, which would only spring into play if it was drawn down a significant amount. Even still, revolver lenders roll over on these covenants pretty customarily as they do not want to own the business).
As the company addressed some of its debt problems, the stock moved up to $15/share ~1 year later for ~150% return.
This to me is a clear example of the 2-3 items I noted above (except for number 3, which I’ll show more below). The problem for some investors is that the volatility in share price can pick up because of this, but as Warren Buffet likes to say, if your neighbor shouted a price to buy your home everyday, would you panic and sell if the number he shouted began to go down? Certainly not.
Let’s then look at an example of purchasing a home. We all know the math – buy with a mortgage and assume it will be covered by rent. As you can see, putting 20% down on a house and assuming no growth in rent or home price appreciation provides a nice little IRR. This is because we were able to buy an asset we otherwise couldn’t afford and essentially have it paid for by the rent. Notice below each dollar of debt paid down accretes to the the equity.
You are essentially LBO’ing your home — every homeowner in America is in the LBO market!
(Note, I assumed a 5% mortgage rate here)
Now that is pretty good, but what if you were looking at an investment of solid property, same assumptions. This will be an investment for you that you plan to sell in 5 years, but you have to pay a 5.5% mortgage rate to compensate for higher risk (i.e. putting less cash down).
As a result, you get a 70% return on your money (vs. 40% in the first example) and put less down which frees up capital to put elsewhere.
The key here is that I am assuming this is a good, solid property. Maybe the best house on Main street that will keep its value and decline.
Said another way, if you view a high quality company as a stream of cash flows, then levering those cash flows can help boost returns.
Let’s say you bought a 5% coupon bond trading at 95 with 100% equity. If you held it to five years to maturity and sold it at par (or 100) your IRR or yield to maturity would be ~6.2%.
Now lets say you bought that bond by borrowing half of the purchase price with debt, funded at 3.5% (which Interactive Brokers actually offers, so I’m not being crazy). The IRR then boosts to 8.8%.
There’s clearly risk here if the bond does not return par, since leverage cuts both ways. If the bond only paid back 90 cents on the dollar, you’d be down ~10% instead of only 5%.
All in all, this is no different than private equity. They have tremendous returns partially because they don’t have to mark-to-market every day like public equity fund managers do. That’s why I like these scenarios as a long-term investor. In the case that something goes right for these levered assets, that obviously provides even more upside.
As I result, I have invested in past in names that were levered 8x when I thought the business was worth 6x when I thought the fundamentals were moving in the right direction and EBITDA growth would help the leverage scenario. I’ve also bought into companies that were in the middle of negotiating covenant relief with banks, as banks typically will provide relief if it is a result of 1x issues or even a cyclical issue that is expected to pass in the longer term and the company can still make payments.