A Hidden Danger in the Corporate Debt Markets

A hidden danger in the corporate debt markets... A shocking new report from Fitch Ratings... Is the global borrowing binge even more extreme than we knew?...

As regular Digest readers know, we believe an historic reckoning is approaching...

U.S. companies have taken advantage of super-low interest rates to binge on debt like never before. Since the financial crisis, total corporate debt outstanding has surged to a mind-boggling $9 trillion. That's an increase of 70%... and it represents an all-time record level of corporate indebtedness, both nominally and as a percentage of gross domestic product ("GDP").

However, interest rates are now trending higher for the first time in years... just as a virtual tide wave of this debt is about to come due. All told, a record $4 trillion must be paid off or refinanced over the next five years.

In short, never before has so much debt come due in such a short (and inopportune) period of time... which means the coming crisis could be one for the record books.

Again, none of this should be news to Digest readers. We've been tracking these growing risks more closely than anyone over the past few years.

But a little-noticed report from "big three" credit-ratings agency Fitch last week suggests the dangers lurking in the corporate-debt markets could be even worse than we knew.

It all began with the collapse of British construction firm Carillion earlier this year...

The company – which was the U.K.'s second-largest construction and services firm, and a leading government contractor – announced it would liquidate back in January.

Most of the details leading up to Carillion's bankruptcy aren't particularly unusual or noteworthy. By all accounts, it was a poorly run business in a low-margin industry which overextended itself on a series of large projects and eventually collapsed under the weight of its unsustainable debt load.

But what was noteworthy was just how much debt the company was carrying.

You see, the company was liquidated with roughly GBP900 million ($1.2 billion) in net debt (not including roughly $1 billion more in unfunded pension liabilities). Yet the company's most recent financial statements reported it was carrying just GBP219 million ($288 million).

How was this possible?

It turns out the company was taking advantage of an accounting loophole to conceal a huge amount of this debt from investors. This loophole involved a technique known as "reverse factoring."

Now, a full explanation of this technique is well beyond the scope of the Digest...

But in simple terms, it works something like this...

In many business transactions, there's a lag between the time when a seller delivers a product or service and the time when the buyer pays for that product or service. If you've taken any basic accounting courses, you likely know these outstanding balances are known as "accounts receivable" to the seller and "accounts payable" to the buyer.

Traditional "factoring" is a common business practice where a seller – typically in industries with a substantial or erratic lag time – will go to a bank and take out a short-term loan against its accounts receivable. Borrowed funds are then paid back to the bank with interest when the seller receives payment.

You can think of it as something like the corporate equivalent of a payday loan. The seller is paying a fee to get paid sooner than it otherwise would.

'Reverse factoring' is similar...

Only it's the buyer rather than the seller who arranges financing.

In this case, the buyer arranges for a bank to pay the seller more quickly, in exchange for a discount on the total paid. The buyer then pays this loan back to the bank (a fee) at a later date.

Again, the seller gets paid sooner than it otherwise would. But in this case, the buyer can also take advantage of longer payment terms than it would otherwise receive. Under the right circumstances, it can be a win-win for both parties.

This is what Carillion did... Beginning in 2012, it told its suppliers (sellers) that it would now pay them no earlier than 120 days after delivery. However, if they didn't want to (or couldn't) wait that long, the company had arranged for a bank to pay them sooner.

As a result, it was able to extend its average payment terms significantly.

But Carillion took advantage of another benefit of this technique...

Again, the details are complicated. But because this transaction provided financing to its suppliers rather than the company itself, Carillion was able to classify this debt differently in its financial statements. As Fitch noted in its report last Friday...

A technique commonly referred to as reverse factoring was a key contributor to Carillion's liquidation as it allowed the outsourcer to show an estimated GBP400 million to GBP500 million of debt to financial institutions as "other payables" compared to reported net debt of GBP219 million.

The debt classified as "other payables" was unnoticed by most market participants due to the near complete lack of disclosure about these practices and the effect on financial statements. Whether these programs require disclosure under accounting standards depends greatly on their construction.

In other words, Carillion was able to legally "hide" hundreds of millions of dollars of additional debt in plain sight, and practically no one noticed until it was too late.

Unfortunately, this problem may not be limited to one rogue U.K. firm...

According to Fitch, this practice could already be widespread in the U.S. and around the globe. More from the report...

We believe the magnitude of this unreported debt-like financing could be considerable in individual cases and may have negative credit implications...

As a result, evaluating trends in payables days is the best way to uncover the use of supply chain financing. To ascertain the scale of the practice and whether an increase in reverse factoring is occurring, we analyzed historic payables days from 2014 to 2017 across a sample of 337 US and [Europe, Middle East, and Africa] rated entities. Median payables days were highest in 2017, rising 14 days since 2014. Extrapolated across our sample this suggests an overall increase in payables of USD327 billion.

In other words, Fitch found that average "payables" among this sample rose by nearly $1 billion per company over the last few years.

To be clear, the firm notes it's unlikely that reverse factoring is the only driver of this increase, but it does highlight just how common it could be.

If this practice is even remotely as widespread as Fitch believes, it could pose a serious problem...

First, it suggests that many of today's heavily indebted firms could actually be far weaker than they already appear.

More important, when the credit default cycle finally does begin, these "hidden" debts could significantly hasten these firms' demise.

You see, unlike other corporate debt with a set maturity date, these debts can be called by the banks on short notice. When credit begins to tighten, these firms could be suddenly on the hook for large additional payments when they can least afford them.

New 52-week highs (as of 7/31/18): Blackstone Mortgage Trust (BXMT), Disney (DIS), Ingersoll Rand (IR), iShares U.S. Aerospace and Defense Fund (ITA), and Williams Partners (WPZ).

Another quiet day in the mailbag. What's on your mind? Let us know at feedback@stansberryresearch.com.

Regards,

Justin Brill
Baltimore, Maryland
August 1, 2018