Letter number 150 of April 2023
- QUESTIONS & COMMENTS
On the previous issue of the Vernimmen.net Newsletter we saw how the equity analysts, 11 out of 13 of whom had a Buy recommendation with price targets of between €110 and €155 for a share price of €90 at the end of 2021, had been misled by the IFRS 16 standard. This had led them to massively underestimate Orpéa's debt, and to overestimate the share price by the same amount, which explains their recommendations at the time. Orpéa's share price collapsed to €2.5, a level we continue to consider overvalued, following the investigative work carried out by journalist Victor Castanet. Without these revelations about Orpéa's management, which could not be detected by reading the published accounts, it seems clear to us that Orpéa would have been in serious financial difficulty in 2022-2023, given its very fragile financial situation as shown by its accounts as at 30 June 2021, the last ones published before the scandal broke.
In this second part, we look at other smaller mistakes made by equity analysts, so that you too can avoid making them; and we look at how debt analysts may also have made mistakes, even though they had avoided the IFRS 16 trap by excluding the effects on the accounts as we recommend.
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On the equity analyst side
As for the equity analysts, who took Orpéa's accounts post IFRS 16 as they were, let us point out three main errors made by some and not by all:
1/ In the cash flow statement regarding future years, in the items related to financing, a line dedicated to the repayment of the rental debt (corresponding to the rents paid) was omitted, whereas it is necessary so that the cash flow statement would end on the variation of the net debt or the cash available and in banks, depending on the approach adopted.
2/ When calculating net debt/EBITDA ratios, take post IFRS 16 EBITDA (i.e. grossed up by rent paid), but take net bank and financial debt excluding rent debt, which gives the best of both possible worlds, but which is an illusion.
3/ Calculating an entreprise value/free cash flow ratio, taking for the entreprise value that of the equity and not that of operating assets, which makes the ratio non-homogeneous, since the free cash flow goes to the community of shareholders and lenders, and not only to the shareholders.
Unfortunately, these errors are not always made by young people, and well-trained analysts also make them. Errare humanum est.
Finally, we note with satisfaction (and relief) that none of the analysts whose work we read was one of our former students.
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On the debt analyst side
The vast majority of the gross debt as at 30 June 2021, €6.3bn out of €8.3bn, is secured debt, i.e. with guarantees taken out on Orpéa's assets (mortgages, pledges of securities). Here are lenders who have not forgotten the fundamentals of the business and who do not regret it today! This is unlisted debt on which there is not much information.
Concerning unsecured debt (convertible or non-convertible bonds, Schuldschein, unsecured bank loans), i.e. €2bn as at 30 June 2022, the predominant reasoning is quite different. It is based on an opco/propco logic. The debt analyst distinguishes between the value of the real estate held by a first entity (the propco) and the value of the operations carried out by a second entity (the opco). This implicitly assumes that the propco could sell the entire property portfolio, with the operating company then renting out all of its property to third parties.
Both Korian (a direct and very comparable peer to Orpéa) and Orpéa indicate that the leverage ratios imposed by their unsecured lenders are adjusted for the amount of the real estate debt (the secure debt). EBITDA is also restated (Orpéa states that 6% of the real estate debt is subtracted from EBITDA) as if the company had sold enough real estate assets to pay off all of its real estate debt and was now renting these assets at a yearly cost of 6 % of their value. That is to say, the overwhelmingly prevailing ratio is:
net financial debt - property debt
EBITDA - 6% x property debt
Unlike equity analysts, debt analysts have banned IFRS 16 as we recommend. Most lenders and debt analysts reason with restated IFRS accounts, where operating lease rentals are treated as operating expenses that are deducted for the calculation of EBITDA, without capitalisation of their amount in the assets and liabilities of the borrower's balance sheet.
For Orpéa, real estate debt represents the bulk of net debt in mid-2021 (€6.4 billion out of €7.4 billion of net debt, or 87%). This allows the group to post a net debt/EBITDA ratio of 3.7 and not 11.4 if calculated on the basis of all the debt. Is this a figment of the imagination? Certainly not, because lenders share this approach and thus assess the solvency of the company. It is therefore difficult to accuse the company of misrepresenting its financial situation, since this is what the creditors are asking for, and its competitors are doing the same.
If we compare Korian and Orpéa in the light of these restated ratios, the financial structure of the two groups does not seem to be significantly different: 3.7 for Orpéa against 3.4 for Korian in mid-2021.
However, the conclusion is quite different if we look at the unadjusted ratios (11.4 x for Orpéa and 5.7x for Korian). The explanations are simple:
- Orpéa holds a larger share of its real estate than Korian (47% versus 24%).
- Orpéa’s real estate is financed with more debt than Korian’s. Thus, the amount of real estate debt in relation to the value of the assets (LTV) reaches 81% for Orpéa, whereas it is only 55% for Korian.
If in terms of adjusted ratios the two groups are close, Orpéa's unsecured creditor is behind much larger secured creditors, who have themselves taken much more risk than Korian's.
Judging Orpéa's financial situation on the basis of a net debt to adjusted EBITDA ratio of 3.7 means focusing on approximately €1bn of net debt (€2bn of gross debt) out of a total of €7.4bn of net debt (€8.3bn of gross debt), and forgetting or overlooking €6.4bn of real estate debt financing €7.9bn of real estate. It is therefore taking the risk of seeing the mote and not the beam.
Moreover, the creditors behind this €1bn of net debt are more junior than those holding the €6.4bn of real estate debt... Given the high proportion of debt used to finance real estate assets (81% of the value of the assets, bearing in mind that Orpéa revalues its real estate assets every year), it is likely that in the event of difficulties or a downturn in the real estate market, the amount of real estate sold will not be sufficient to pay off the real estate debt...
The fundamental question is then to assess the market value of the real estate assets and, if cash flow generation weakens, the capacity to monetise them to lighten its financial structure. Orpéa revalues its property assets in its accounts mainly by capitalising the rent for each asset. This assumes that a company of the same type will continue to rent this asset. If a reallocation of the building to another use were necessary, there is nothing to say that such values are feasible.
Finally, the restated leverage ratio is very dependent on the assumptions used in its calculation. If the implicit rent rate is not 6%, but 6.6% (or what amounts to the same thing if the value of Orpéa's real estate is overestimated by 10%), Orpéa's debt/EBITDA ratio goes from 3.7 to 4.3... For Korian, the situation is very different and it is much more balanced between real estate debt (€1.6bn) and overall net debt (€3.2bn). At the same time, the restated ratios are less sensitive to the assumptions made (increasing the capitalisation rate by 10% only increases leverage by 0.1).
Finally, the share of real estate debt financing of real estate assets is much lower than that of Orpéa, thus implicitly leaving part of the value of the real estate available for unsecured creditors in case of disposal. Korian's financial situation has nothing to do with Orpéa's, so let's not mix things up!
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Orpéa's unsecured lenders will, in the restructuring plan that has been announced, lose 70% of their receivables and exchange the balance of their receivables for shares with a more volatile value than debt. Some of these are funds (Anchorage, Boussard & Gavaudan, etc.) which bought unsecured debt on the over-the-counter market at prices probably around 20% of the nominal from the original lenders who thus lost 80% of their loans.
The opco/propco reasoning is undeniably very interesting from an intellectual point of view. It is often used by shareholders of companies with a strong real estate component who want to maximise the value of their shares. In the Orpéa example, as in other similar examples, the opco/propco reasoning has led to situations of over-indebtedness (classic net debt/EBITDA ratio of 11.4 in June 2021, twice that of Korian) when apparently everything was going well.
While it is understandable that the shareholder seeks to maximise the value of his shares, and that opco/propco reasoning can help him to do so, the lender, especially one without guarantees, is not intended to lend to the maximum extent possible.
It therefore seems preferable to us that, in terms of debt, analysts should be content with conventional tools (total bank and financial net debt/total EBITDA, excluding IFRS 16), without going into the high realms of financial engineering, unless they run the risk of ending up like Icarus.
Few credit analysts reasoned in this way, but those who did were much more likely to advise their debt investor clients to sell the Orpéa loan, like, for example, the analyst at Octo Finances since 2018.
World-wide corporate tax rates have fallen slightly to an average of around 23.4%. They have now risen back above 21% in Europe on average, but are still low due to lower corporate tax rates in Eastern Europe. And at the OECD level, the average has risen above 23% thanks to the UK, which has risen from 19% to 21%, before reaching 25% this year.
With Simon Gueguen, lecturer-researcher at CY Cergy Paris University
Financial flexibility (holding cash, low financial leverage) has the advantage of protecting the company in the event of a specific or macroeconomic shock. In fact, at first sight, this is a simple mathematical effect, as Hamada showed in 1972 : the beta of a share increases with its debt-to-equity ratio. In practice, the precise link between financial flexibility and stock sensitivity to events is difficult to measure because the level of a company’s exposure to shocks depends on its sector or business model. The Covid crisis is a perfect example: while it was undoubtedly a shock that affected the entire economy, companies that were heavily involved in international trade or that depended on physical outlets were more affected than others. This month's article measures the (positive) impact of financial flexibility on the resilience of stock prices during the Covid shock.
On a large sample of listed US companies, Fahlenbrach et al assessed the degree of financial flexibility according to the cash held and the amount of debt (short-term and long-term) on the liabilities side, relative to the size of the balance sheet, just before the crisis (in the accounts published at the end of 2019). Then they compared the stock market performance of these companies between 3 February and 23 March 2020, when the markets collapsed. The result is very clear: the drop in the stock price of companies with high flexibility was 26% less than that of companies with low flexibility.
Our loyal readers may argue that the smaller stock price drop at low-leverage companies during the crisis is not surprising and is simply a manifestation of debt leverage. If this were the case though, the stock price recovery would also have been stronger for highly leveraged companies. Fahlenbrach et al found that this is not the case.
Also, the collapse of stock prices at the time of the shock was accompanied by a sharp rise in volatility. According to models that consider the stock as a call option on the operating assets , this increase in volatility should be favourable to high beta stocks. Fahlenbrach et al measure that the theoretical relative gain from this rise in volatility is close to the loss from the fall in prices. In other words, the purely mathematical effects predict a price drop that is not very different depending on the beta. They conclude that the observed benefit of financial flexibility comes from real protection against such shocks, and that it is not a simple capital structure effect.
Furthermore, Fahlenbrach et al show that, for an equivalent leverage effect, the companies most exposed to the crisis (because of their sector or their business model) are also those for which cash holdings provided the best buffer for falling stock prices. A company located in the 75e percentile in terms of cash holdings saw its stock lose 7.3% more than a company in the 25e percentile when its exposure to the Covid crisis was high.
The interest of this article is that it highlights, in a rigorous manner and using a spectacular example, the importance of financial flexibility as a crisis buffer. As Fahlenbrach et al point out, activist investors often direct their campaigns towards reducing this flexibility : increasing financial leverage and reducing cash holdings via share buyback campaigns or dividend increases.
In theory, under the assumptions of Modigliani Miller in 1958, capital structure is neutral. In practice, the incentive (and possibly fiscal) virtues of financial leverage are opposed to the benefits of financial flexibility which, according to this article, persist after crises. The search for the ideal capital structure remains a huge undertaking, the Holy Grail of corporate finance.
 R. Hamada (1972), "The effects of the firm's capital structure on the systematic risk of common stocks", Journal of Finance No. 27, pages 435-452.
 R. Fahlenbrach, K Rageth and R.M.Stulz (2021), "How valuable is financial flexibility when revenue stops? Evidence from the Covid-19 crisis", Review of Financial Studies, No. 34, pp. 5474-5521.
Net Asset Value (NAV) financing is financing raised by an investment fund that pledges all of its assets (whose aggregate value is the NAV) as collateral. The fund may be a private equity fund (LBO, venture capital) or a debt fund.
Traditionally, investment funds were simply a receptacle for securities purchased and financed entirely by equity (contributed by limited partners or LPs). If there was any debt, it was backed by assets, in a specific acquisition holding company as for an LBO fund, but not at the level of the fund itself. However, some funds are raising debt at their own level. These debts can have several motivations:
- To give themselves flexibility in their investment policy (typically, some financings just anticipate by a few weeks or months the call for funds from investors at the time of a new investment, they are called capital call facility).
- Giving more flexibility in the disposal policy. Indeed, certain periods (such as now) may not be conducive to disposals or IPOs because the markets are closed or valuations unattractive. Debt can then be used to return funds to investors (LPs) before the actual disposal of assets.
- Improve the profitability offered to investors by using leverage. It is always an incentive when funds are called in a little later or repaid a little earlier!
NAV financing meets the latter two objectives. They usually have a term of 2 to 3 years and are repaid when the assets are sold. Where all the capital has not yet been called, the uncalled capital can be used as explicit or implicit security for the financing.
The underlying assets are generally not very conducive to raising debt as they are relatively risky (start-ups for VCs), or already highly leveraged (LBO funds), so the leverage put in place by the funds remains modest. It is rare to see LTV (loan-to-value, i.e. the ratio of the amount of debt to the value of the assets) exceed 20%, it is usually close to 10%.
Funds can also finance only a given investment (called back leverage), but this is often more complicated and costly as banks prefer the diversification provided by the whole asset portfolio. It is usually only encountered when the asset is listed (referred to as a margin loan) and daily margin call mechanisms are used to limit the lender's risk by maintaining a maximum LTV at all times.
NAV financing can also have margin calls, but they are much less secure because they follow the rhythm of the fund's valuations, which are at best monthly, but more often quarterly. Moreover, valuations are not always carried out by an independent third party.
Regularly on the Vernimmen.com Facebook page we publish comments on financial news that we deem to be of interest, publish a question and its answer or quote of financial interest.Here are some of our recent comments.
Getlink's decarbonated EBITDA
Getlink, the parent company of Eurotunnel, has published a new financial indicator that allows extra-financial elements to be integrated into the financial elements, by subtracting from EBITDA a fictitious charge corresponding to the valuation of all its greenhouse gas emissions (scope 1, 2 and 3) at a price more than double that of the current cost of a tonne of carbon (€197 compared to €94).
For Getlink, which has low greenhouse gas emissions, the impact on its profit and loss account is small, with a 3.3% reduction in EBITDA. But for its ferry competitors, that emit 73 times more for the same journey, you can imagine... This also shows the forced transformation that some companies must carry out between 2024 and 2030, in a context where the European Union is going to extend the carbon quota market to new sectors such as maritime transport (well, well...), construction and road transport, or to reduce the volume of quotas that are currently free of charge, in accordance with the polluter-pays principle.
Who will ultimately pay? The customer via price increases? The shareholder via lower profits? The community to relieve sectors that cannot adapt quickly enough? It remains to be seen.
In any case, as we explained in the last edition of the Vernimmen, it is easier for investors to take into account the externalities that companies impose on the planet if their costs appear in the profit and loss account, rather than in an appendix, another document and quantified in tonnes, litres or kWh, and not in euros. This is why we welcomed Danone's decarbonated EPS as a first step in this direction, even if Danone's approach was focused on the growth rate of its decarbonised EPS 2019, which was higher than for the classic EPS since the food group had reached its peak of greenhouse gas emissions. As far as we know, no other group has followed suit and Danone has stopped publishing it for three reasons: Covid, which caused its decarbonised EPS to decline faster than conventional EPS, the sharp rise in the price of carbon credits from €35 to €94 in Europe, which would have put decarbonised EPS at a loss, and probably the change in CEO.
Does the decarbonisation margin have a better future? Probably, since its proponent does not risk being caught out like Danone, being a low emitter of greenhouse gases; and because the time when this theoretical cost could well become a real cost is much closer.