Recently my business Partner, Preston McSwain, heard the following remark over breakfast with one of the largest private direct-deal investors in the nation.
“We all know that the D and A in EBITDA can be ‘delusional accounting’ but it is ‘accepted’ so we work it.”
Unfortunately, I’ve heard similar quotes from other seasoned investors.
Those of us who have been in the business for many years know that all that matters in the end are cash on cash returns that investors receive, but we continue to see, more often that we appreciate, EBITDA, and other valuation and return metrics that do indeed seem to be “worked.”
Nothing is technically wrong with the way most presentations are made, but the disclosure requirements on private deals are often lacking, to say the least.
We all know that some in the industry have this job:
“As long as the music is playing, you’ve got to get up and dance.”
When acting as a fiduciary of your personal wealth, or the wealth of others, however, consider taking a step back from metrics such as EBITDA and IRRs that can be played to the advantage of the fundraisers or sellers of a company, deal or fund.
Follow the cash flows and demand simple accounting of returns that reflect true cash on cash returns that investors have actually received.
Preston wrote a recent personal blog on this subject that referenced the poem listed below, Watch Cash Flow.
He ended his post with this question about the poem:
“Considering that the industry is generally playing with other people’s money, should this old rhythmic verse by played over and over again?”
I think so.
Watch Cash Flow
Once upon a midnight dreary as I pondered weak and weary
Over many a quaint and curious volume of accounting lore,
Seeking gimmicks (without scruple) to squeeze through
Some new tax loophole,
Suddenly I heard a knock upon my door,
Only this, and nothing more.
Then I felt a queasy tingling and I heard the cash a-jingling
As a fearsome banker entered whom I’d often seen before.
His face was money-green and in his eyes there could be seen
Dollar-signs that seemed to glitter as he reckoned up the score.
“Cash flow,” the banker said, and nothing more.
I had always thought it fine to show a jet black bottom line.
But the banker sounded a resounding, “No.”
Your receivables are high, mounting upward toward the sky;
Write-offs loom. What matters is cash flow.”
He repeated, “Watch cash flow.”
Then I tried to tell the story of our lovely inventory
Which, though large, is full of most delightful stuff.
But the banker saw its growth, and with a might oath
He waved his arms and shouted, “Stop! Enough!
Pay the interest, and don’t give me any guff!”
Next I looked for noncash items which could add ad infinitum
To replace the ever-outward flow of cash,
But to keep my statement black I’d held depreciation back,
And my banker said that I’d done something rash.
He quivered, and his teeth began to gnash.
When I asked him for a loan, he responded, with a groan,
That the interest rate would be just prime plus eight,
And to guarantee my purity he’d insist on some security—
All my assets plus the scalp upon my pate.
Only this, a standard rate.
Though my bottom line is black, I am flat upon my back,
My cash flows out and customers pay slow.
The growth of my receivables is almost unbelievable:
The result is certain—unremitting woe!
And I hear the banker utter an ominous low mutter,
“Watch cash flow.”
– Herbert S. Bailey, Jr. – 1975
Are We Baking Portfolios with Bad Ingredients? – Tommi Johnsen, PhD – Research Round Table
Private Access – Should We Beware? – Preston McSwain, Chief Investment Officer, Fiduciary Wealth Partners