Thread by @tracyalloway

Let's talk about earnings quality and credit. 43% of syndicated loan deals featured Ebitda addbacks in the first half of this year. That's a record proportion, according to BAML. If you strip those addbacks out, Ebitda/Interest coverage levels on loans are the lowest since 2005.

(Let me tell you about my pet theory that Valeant's aggressive use of addbacks and debt financing to engineer artificial growth in a sluggish economic environment is actually representative of the entire market.)

(Ok here goes). First a recap. I think most people remember Valeant as the Canadian pharma company that expanded really rapidly by borrowing billions to fund mergers and acquisitions. Share prices soared and then began tanking in late 2015 as a number of issues came to light.

Again, the strategy here wasn't a secret. Hedge funder Bill Ackman (initially a big supporter/investor of Valeant) described the attraction in his 2016 apology to Pershing Square shareholders.

acquirersmultiple.com/2017/04/bill-a…

Here's the quote: "When we acquired Valeant, we viewed our purchase price as representing a modest discount to the value of the company’s existing assets..."

... "but a large discount to intrinsic value in light of our expectation that management would continue to be able to invest capital in new transactions on terms that would create significant long-term value as it had done over the previous eight years.”

Valeant's roll-up strategy was basically a feedback loop between capital markets and equity valuations. You borrow billions from bond investors to fund acquisitions that justify a larger valuation for stock investors.

(This is where the addbacks come in. I wrote about this a while ago, but basically if you can demonstrate continuous future growth you also flatter your borrowing costs, which lets you borrow more to fund more deals for more future growth potential.)

bloomberg.com/news/articles/…

So what does this have to do with the wider market? We've had tons of debt-financed share buybacks and M&A deals. The feedback loop here is: borrow money to boost growth prospects --> better growth prospects let you accumulate more debt --> so you can then borrow even more money

Again, the backdrop to all of this is sluggish economic growth that makes organic growth hard. If you can't grow profits 'naturally' then you can do so through deals.

Surely the market would see through this right? No. For a long time investors rewarded companies that have undertaken mergers/buybacks, versus companies that had, you know, invested in capex or some crazy thing like that.

(Every once in a while you would see some sell-side research talking about this. E.g. Goldman Sachs complaining about the efficacy of capitalism circa 2016: bloomberg.com/news/articles/…)

Anyway, the pet theory is that Valeant is a microcosm of overall market behavior. Companies are incentivized to engineer growth as rapidly as possible, so as to justify higher valuations and lower borrowing costs.

Meanwhile, investors (up until recently) rewarded that behavior because cost of capital was basically free and it created that feedback loop for higher share prices. And in an environment where investors are chasing flows, rather than 'value,' you really want that feedback loop

That's it.