the First Brands Group collapse

Unlock the Editor’s Digest for free

Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

Martin Mulyadi is a professor of accounting and Yunita Anwar is an assistant professor of accounting, both at Shenandoah University, Winchester, Virginia.

In late September, First Brands Group, a privately held US auto parts company, filed for bankruptcy protection. The petition listed total liabilities of $10-50bn. FBG and related entities carried more than $8bn of secured corporate borrowings and inventory-backed financing. In the wake of the company’s collapse, investigations of its off-balance-sheet financing arrangements have highlighted the limits of what can be learned from public financial records alone.

In FBG’s case, the central issue was its use of multiple forms of working capital financing, including leasing structures that were not clearly disclosed to other lenders. Rating agencies had already noted an increase in factoring, through which a company sells its unpaid invoices to a third party. Rating agencies said they were including off-balance-sheet factoring and parts of supply-chain finance in their own debt calculations.

This highlighted the fact that much of the company’s working capital finance lay outside reported debt, much of which was based on receivables. Because factoring is usually structured as a sale rather than a loan, this did not add debt to FBG’s balance sheet, even though rating agencies treated them as debt-like when assessing its leverage.

Inventory-backed funding was also used. Utah-based leasing firm Onset Financial, which had originally loaned equipment to FBG, became its largest creditor, asserting a claim of about $1.9bn, and says it is the rightful owner of leased inventory and equipment and told the Financial Times that senior executives and independent inspectors visited facilities as part of diligence.

These arrangements, while economically debt-like, were made through leasing structures that were not clearly disclosed to other lenders, many of whom were unaware of them until the bankruptcy filings. Separately, some prospective inventory-finance providers reported proposals for repo-style monetisation — which involves selling existing inventory to the provider and then buying it back later — at fees in the mid-teen percentages, which were unusual compared with the 5 to 8 per cent typically expected. Providers cited urgency as a concern and several declined to participate.

Several off-balance-sheet financing entities tied to FBG entered bankruptcy shortly before the company itself. These entities raised funds through high-yield, short-term instruments linked to FBG’s inventory and receivables.

An FT Alphaville review indicated coupons of 14 percentage points over the three-month Secured Overnight Financing Rate, the loan market’s commonly used floating-rate benchmark (about 19 per cent) and Level-3 fair-value classifications (where a market price is not used to determine their valuation), signalling both high returns and limited transparency.

After the filing, asset-backed lenders sought to trace cash movements among operating companies, special-purpose entities and segregated accounts. Counsel asked whether receivables and inventory had been pledged more than once or commingled. Such questions went to the core of how the structures operated day-to-day, rather than how totals appeared on a balance sheet.

As a private company, FBG was not required to publish its accounts, so stakeholders relied on confidential lender presentations, rating agency reports and limited borrower-provided information. The type of financing techniques FBG used are generally not included in a company’s debt figures and are sometimes treated as off-balance sheet. Because they are not counted in the “headline debt” total on the balance sheet, simple leverage ratios based on that figure can understate how much financing the company is actually using. This reporting convention helps explain why rating agencies said they adjusted debt to incorporate such programmes.

Until the week of bankruptcy filing, many lenders were also unaware that FBG had billions of dollars in inventory-backed loans via off-balance-sheet special purpose entities. After the filing, one asked how much of the almost $2bn advanced to FBG remained in a supposedly segregated account and was told: “$0”.

FBG’s financing mechanisms raise other questions. For example, some FBG executives invested in Onset-linked leasing deals that charged FBG double-digit rates. Onset said most of its earnings were reinvested in future transactions and in court filings asserted that it was the rightful owner of leased inventory and equipment. Without alleging wrongdoing, such arrangements raise standard audit committee and lender questions about decision-making incentives and disclosures when the operating company is also a borrower to a vehicle in which insiders have interests.

Research has found that when off-balance-sheet items are brought on to the books, overall financial reporting quality tends to improve while greater transparency on use of certain forms of debt financing is helpful to lenders.

Across the filings and reporting, three features stand out:

• Significant use of receivables and inventory funding, some through special purpose entities and leasing vehicles, alongside traditional loans

• A rapid liquidity squeeze, including a seized transfer and queries about segregated accounts showing $0.

• Disclosures in the petition of more than $8bn of secured and inventory-backed obligations, plus a $1.1bn lifeline and a special committee to examine off-balance-sheet arrangements.

Rating-agency adjustments for factoring, the prevalence of Level 3 valuations and high coupons in fund filings and the pause of a $6bn refinancing are signals a diligent reader might have been able to spot. But given the private-company context, classification of supplier finance and contract-level cash controls and collateral-priority questions, only clarified after filings, the accounts could only reveal so much.

Recent FT reporting that a small group of lenders refused credit, exited positions or shorted FBG debt after identifying anomalies in fees, deal structure and reported performance suggests that warning signs were visible. Yet they did so only after field examinations, collateral reviews and direct meetings, pointing to limits in what can be inferred by outsiders from public financial records alone. What, if anything, could have been legible in FBG’s accounts?