Practical analysis for investment professionals
09 August 2019

Rising Risk: Accounting Shenanigans and Alternative Investments

Seasoned auditors know that the risk of fraud increases when a client experiences brisk organic growth or M&A activity. During the 1990s, the most spirited dealmakers included telecom operators building the backbone of the internet and media groups trying to capitalize on the conversion of content and distribution.

Accounting scandals at WorldCom, Global Crossing, Qwest, Lucent, and Adelphia confirmed that external auditors (and investors) should have paid closer attention. Value-destructive transactions with dodgy accounting and aggressive leverage were common — the AOL-Time Warner and Vodafone-Mannesmann mergers in 2000 are prime examples. AOL, in particular, was later accused of inflating revenues — on which valuation multiples were applied — by booking ads it sold on behalf of third parties.

Other deal junkies included major energy producers and distributors taking advantage of deregulation. Enron may be the best-known blow-up, but rivals Duke Energy, Dynegy, and CMS Energy had some improprieties as well.

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The Limits of Sarbanes–Oxley

Another hallmark of that era? Conflicts of interest within audit firms. At Enron, Arthur Andersen generated more fees from consulting services than from auditing the energy giant. The Sarbanes–Oxley Act (SOX) was passed in 2002 to address such issues.

Yet, today SOX is showing its limits. As audit firms cover global alternative asset managers like Apollo Global Management and Blackstone, they also offer various advisory services — from transactional due diligence to M&A support and strategic reviews — to the portfolio companies of private equity (PE) firms. In 2018, Deloitte, the auditors of KKR, earned $27 million from audit fees, $13 million from audit-related fees, and over $43 million from tax fees. But the accountancy firm also generated over $32 million from advisory fees charged to KKR’s investee businesses.

Andersen Consulting had been hived off from the audit arm of Arthur Andersen to abide by SOX’s principles. The other multi-disciplinary accountancy groups followed suit: In 2002, PricewaterhouseCoopers (PwC) unloaded their consulting arm to IBM; Ernst & Young (E&Y) shopped their IT consulting practice to Capgemini; and KPMG sold their consulting practice to Atos Origin.

But in the past 10 years, the Big Four accounting firms have reversed course, adding to their service offering either organically or through acquisitions. PwC bought strategy consultancy Booz & Company in 2014, for instance.

Deloitte proved more farsighted than its peers, retaining its consulting arm in 2003 after considering a demerger under the Braxton brand. Ten years later, it even absorbed management consultants Monitor.

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The Big Four’s Loss of Independence

While audit independence criteria grew stricter in the years after Sarbanes–Oxley, there is still cause for concern. Should potential independent auditors also help the PE groups’ investees evaluate commercial strategies, establish operational structures, and prepare IPOs?

What would happen to these advisory relationships if the auditor of a large alternative asset manager chose to qualify the latter’s accounts? The client could retaliate by banning portfolio companies from employing the services of the audit firm.

This is not a moot point. Three years ago, Bain Capital took Ernst & Young to court in the United States, claiming it botched the financial review and falsified the accounts of an Indian company in which Bain invested alongside TPG Capital.

Considering that E&Y audits 5 of the 10 largest PE groups in the United States, it is perhaps fortunate that neither Bain Capital nor TPG is among its audit clients. But what is telling is Bain Capital’s reference in its 75-page lawsuit to E&Y’s perceived conflicts of interest, given the accountancy firm’s involvement both as auditor and financial adviser to the target company.

With alternative asset managers Apollo, Blackstone, KKR, TPG, and The Carlyle Group holding equity and debt positions in hundreds of companies, any of these giants could deliver a painful blow to one of the Big Four.

Earlier this year, three of the Big Four announced they would stop selling consulting solutions to their audit clients — something we thought had been enacted by SOX. Nevertheless, the provision of transaction services to portfolio businesses represents a bigger risk of conflicts, especially since accounting and reporting shenanigans have returned with a vengeance.

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Accounting Tricks: Back in Vogue

Today, PE fund managers are the top deal doers and compose a new form of multinational corporation. Their tricks are overleverage and creative accounting. Sound familiar?

Just as valuations of Enron, WorldCom, and other hyperactive dealmakers of the 1990s stretched the imagination and, eventually, the bounds of the legally permissible, in the current bubble, elements of the PE groups’ portfolios could be manufactured or artificially enhanced.

In the 1990s, accounting tricks massaged earnings per share (EPS) to inflate the stock price above its true value so that corporate executives could exercise their stock options.

Nowadays, what is manipulated is not EPS, but EBITDA. And EBITDA is proving a malleable substance. In fact, as a chartered accountant, I believe EBITDA may be more pliable than EPS.

Think about it. Unlike EPS, EBITDA is not an audited metric. It is simply a number corporations voluntarily provide to help lenders and equity analysts compare them with their peers. That leaves plenty of room to get inventive.

Adjusted EBITDA was always a core instrument of the PE toolkit, but fund managers have pushed the envelope when deciding what to include in their calculations. Items are being randomly added to (or subtracted from) this free cash flow proxy. The main rationale behind these adjustments — dubbed “EBITDA addbacks” — is to negotiate fatter debt packages with lenders and to boost exit valuations.

To understand this approach, imagine a business is about to acquire a competitor and expects to generate synergies from the transaction. Such synergies might take a couple of years to materialize, but the acquirer’s management team will recognize these future cost savings and revenue increases in this calendar year’s EBITDA number to generate a “run rate.” This reduces the leverage ratio and raises the expected enterprise value.

Such aggressive accounting practices are reminiscent of those from the 1990s, such as timing the recognition of gains and losses to minimize tax liabilities or artificially inflate earnings to revitalize the stock price. Once again, since EBITDA is not an audited number, no outside party needs to check the math.

EBITDA definitions have become negotiable between buyers and sellers. But that cannot change the reality of the underlying business. Investors may pin their hopes on the diligence of external auditors. But given the potential conflicts of interest, they might want to hedge their bets. The next crash may unearth accounting scandals to rival those of Enron and WorldCom.

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Tech Bubble Take Two

If buyout experts are known for innovative financial engineering, start-up executives have started minting new reporting measures to attract ever larger ticket sizes at nosebleed valuations.

Another accounting farce of the 1990s was the internet bubble. Companies with no revenues and huge losses received billion-dollar valuations thanks to creative accounting and a lack of independent audit opinion due to their limited trading history.

Today, tech start-ups also have a bagful of tricks. Which venture capitalist has not encountered new reporting formats and benchmarks?

Remember the terminology around the number of eyeballs and click-throughs that justified valuations during the dot-com era? Nowadays, start-up investors are fed various performance indicators that are, in many instances, all but fabricated. Recently, I encountered an early-stage business that reported monthly numbers with three different kinds of contribution margins: One of them was unmistakably positive while the other two — which included various “non-core” or “one-off” expenses — were very much negative for the foreseeable future.

That contribution margins already exclude fixed* costs is not sufficient for most start-ups to show a profit, but my concern is that entrepreneurs often demonstrate little understanding of the numbers they come up with.

The recent short attack on UK litigation specialist Burford Capital proves that even profitable start-ups can turn into sand castles when a wave of suspicion washes over their accounting practices. By publicly questioning Burford’s operating performance, activist Muddy Waters managed to wipe out two-thirds of the target’s market capitalization in a matter of days before Burford’s management was able to issue a rebuttal.

As the current deal-making bubble enters its final phase, investors should expect valuations to return to earth, brought low by the painful realization that they were spruced up by dubious accounting and reporting policies.

* An earlier version of this article mistakenly said these costs were variable.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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About the Author(s)
Sebastien Canderle

Sebastien Canderle is a private capital advisor. He has worked as an investment executive for multiple fund managers. He is the author of several books, including The Debt Trap and The Good, the Bad and the Ugly of Private Equity. Canderle also lectures on alternative investments at business schools. He is a fellow of the Institute of Chartered Accountants in England and Wales and holds an MBA from The Wharton School.

7 thoughts on “Rising Risk: Accounting Shenanigans and Alternative Investments”

  1. Smehta says:

    Thank you for this wonderful article.
    If you think EBITDA is not good for valuation for private or public companies, then what kind of valuation technique do you suggest which will allow to approximate a company’s true value?

    1. Muhammad Abu Bakar says:

      It depends on firm dividend policies and cashflows etc. You may apply discounted cash flow method:
      1- if firm has a stable dividend policy and
      2- You perspective is that of investors.

      Or you may apply free cashflow to firm or free cash flow to equity models if:
      1- Cash flows of the firm are positive.
      2- Your perspective is that of an owner.

      There are other discounted methods as well. But above given methods are mostly used.

  2. Kirk Cornwell says:

    “Bottom line” is still that to be damaged by an inability to pay debt, one still has to make a loan. “Investment” in financial or other (GE?) companies that do is a choice to take on (affordable [?]) risk. Let’s not worry too much.

  3. Dalton Hicks says:

    Pretty egregious over-simplification, rife with loosely connected vagueries.

    This is an issue of debt providers being willing to underwrite just about anything due to the flood of capital that needs to be deployed, not one of m&a being evil (no matter how often you randomly invoke Enron and WorldCom). This is an issue as, or more, prevalent in the public markets. Any forthcoming IPOs come to mind?

    Second – quality of earnings and financial due diligence is performed on the buy side as well as the sell side. Accepting addbacks comes down to the buyer and their lenders discretion.

    Third – if synergies don’t cone to fruition then that DOES impact a firms compliance with their debt covenants.

    The problem here is oversupply of capital and loose underwriting. It is lazy and irresponsible to invoke Enron and WorldCom comparisons, boiling down PE playbooks to “accounting shenanigans and over leveraging”…. is multiple arbitrage not a real thing? What about the many platforms built around their bench of operating executives? Are more deals not going to long term private capital, which uses less leverage than traditional PE?

    1. Sebastien Canderle says:

      Thank you for your comment, Dalton.

      You write of over-simplification and vagueries, but accounting is not an exact science and is therefore open to interpretation (and manipulation). Accounting scandals are very common and if references to Enron and WorldCom upset you, you can always think of more current examples, including that of Kraft Heinz (partly PE-backed), which recently saw the company restate 3 years’ worth of financial reports.

      Please don’t assume that I am picking on the US. Over in the UK, the last few years have seen many high-profile cases hit the headlines (BHS, Carillion, Patisserie Valerie, Tesco, Sports Direct, …).

      Your assertion that lenders have a say over what EBITDA to apply leverage ratios to ignores the track record of loan providers in that respect. Banks (and private debt funds) employ other people’s money. The subprime mortgage bubble has taught us that bankers will keep on dancing as long as the music is playing, to quote Chuck Prince. Don’t expect them to use their judgment (and question accounting practices) if they know that they can syndicate their loans to third parties.

      You rightly point out that many publicly-listed corporations (including the ones mentioned above) have their share of scandals. My post in no way implied that only PE- or VC-backed companies were users of accounting shenanigans. This is a widespread practice.

      Yet the separation between public and private markets is very porous. Privately-owned businesses are not meant to stay that way forever. Any examination of the post-IPO performance of companies previously PE- or VC-backed proves that poor accounting practices can percolate into the stock markets. You will no doubt have heard of the lawsuits filed by investors against Snap over its disclosure of inflated performance data. You will also have heard that VC-backed WeWork is preparing an IPO and uses a metric called “community-adjusted EBITDA”.

      Again, it would be naïve to think that, in the current bull market, PE and VC fund managers will not be tempted to get creative when valuing their portfolios and reporting performance. Sadly, there is a fine line between creative accounting and fraud. The purpose of my post was simply to raise a few red flags for the benefit of investors (and auditors). That deal makers and M&A advisers think such loose accounting practices acceptable should surprise no one – certainly not someone who has lived through the 1990s.

  4. Peter Filippakis says:

    Just a small typo correction: Contribution Margin excludes Fixed Cost per Unit, it includes Variable Costs per Unit (i.e. Contribution Margin = Price per Unit – Variable Cost per Unit).

    1. Sebastien Canderle says:

      Apologies, Peter. Thank you for drawing attention to this error. It has now been corrected.

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