A series of blow-ups in the world of private credit might be written off by some investors as one-off isolated incidents. True as that may be, they may also be indicative of problems brewing more widely that could spill over into public markets if left unchecked.
Following those highlighted by Michael Gatto of Silver Point Capital, here are an explanation of investing red flags.
Rising receivables
Receivables are a mechanical result of the fact that companies do not make all of their sales for cash – some are on credit. At the end of a given financial period, the unpaid ones show up as receivables or “debtors.”
Whilst a rise may simply reflect increasing sales, it may also indicate a problem converting revenue to cash or a firm forcing extra sales onto distributors in order to flatter the number.
Order backlogs
Whilst having too much demand for a firm’s product might be seen as a good thing, once it becomes systemic, customers may get irritated and switch suppliers. As such, backlogs need to be managed rather than allowed to spiral.
Foreign exchange volatility
Whilst this can be hedged via a fund, for instance, left unchecked, “FX” can flatter profits or do the opposite. For example, if a firm generates $100 of profit when the exchange rate is 1:2; in sterling that is £50, but if profits drop to $50 and the exchange rate moves to 1:1. The sterling profit is still £50 ($50 at a rate of 1:1).
Aggressive acquisitions
Some firms in the private credit space try to grow fast via acquisition, as do firms in public markets sometimes. Whilst there is nothing wrong with that, as such, it can tempt managers who are trying to find growth. For instance, if a target firm generated $100 of profit last year and is expected to do the same this year and also next year. A predator buys in halfway through the current year. The profits included in the new joint profit statement will be $0 for last year, $50 for this year and $100 next year. That could look like growth when in fact the underlying business is flat.
Stock mismanagement
Having a decent level of stocks on a balance sheet might seem like a good thing – it reduces the risk of a “stock out.” However, it can also flatter profits and suggest a problem with forward sales.
Imagine a firm has revenue of $200 and “cost of sales” (direct costs) of $80. If the latter is made up of $10 of opening stock, $80 of purchases and $20 of closing stock. The problem is that if that closing stock number keeps growing, so will profits for a while. However, the commercial reality might be that the business is slowing.
Shrinking operating expenses
Cost control is a good thing. However, watch for firms slashing important investment lines, such as advertising expenditure and research and development spending, in order to prop up profits in the short-term.
