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When The Credit Cycle Turns The EBITDA Add-Back Fallacy

Highlights

- Our review of a sample of transactions originated during 2015 show that on the aggregate level, add-backs inflated projected EBITDA by an average of 45%. This article examines whether add-backs present a more realistic picture of future earnings, leverage and credit risk and whether companies typically achieve the forecasts presented at deal origination.

- Our data indicate that management projections at deal inception were very aggressive; showing that on average, actual reported net leverage was 2.9 turns higher than forecast for 2016, growing to 3.6 turns in 2017. Overstated earnings was the primary contributor to the leverage disparity with reported EBITDA 29% below management projected adjusted EBITDA during 2016, growing to 34% in 2017.

- We conclude that 1) management-adjusted EBITDA including add-backs is not necessarily a good indicator for future EBITDA; 2) companies overestimate debt repayment; 3) combined, these effects understate future leverage and credit risk; and 4) add-backs also present incremental credit risk in the form of future event risk since covenants that rely on EBITDA may provide additional flexibility under negative covenants and restricted payments.

Looking For A More Realistic Picture

Do add-backs present a more realistic picture of future risk, and do companies typically hit their forecasts?

Sep. 24 2018 — EBITDA add-backs are not a new phenomenon, as companies have always sought ways to market the best possible credit story to investors, but in recent years the trend has escalated. Of late, deal purveyors have become increasingly creative in presenting what qualifies as an add-back, resulting in an increase in both the number and types of adjustments. In some of these cases, S&P Global Ratings views the act--expanding the definition of management-adjusted EBITDA to inflate what we will refer to as "marketing EBITDA"--as an artificial deflation of leverage. At the heart of this phenomenon is the absence of a uniform and commonly accepted definition of EBITDA[1]. In practice, it is and has always been a negotiated definition, varying from (credit) agreement to agreement.

In this article, we address investors' expressed concerns about the spate of large EBITDA add-backs; in particular, how often did issuers hit earnings, debt, and leverage level forecasts. Our data examine a sample of large mergers and acquisitions (M&A) and leveraged buyout (LBO) transactions originated in 2015. Our analysis consists of two main components. First, we examine the magnitude and distribution of company add-backs across major categories. Next, we assess the validity and accuracy of these add-backs that companies expected to achieve. Given the difficulty in parsing out the specific components of EBITDA add-backs to make the determination as to their eventual realization, we instead compared issuers' projected adjusted EBITDA at deal inception with the actual reported EBITDA. We note that a portion of the difference between projected and reported EBITDA could be attributable to unmaterialized growth, unanticipated operating issues among others.

Regardless of the findings, we want to be very clear that our rating is based on our projections and view of expected synergies and future EBITDA. Marketing leverage and the language around add-backs as defined in debt agreements do not determine our view of credit risk (other than when assessing compliance with financial maintenance covenants). We often do give some credit to certain add-backs or synergies. However, we are almost always considerably less optimistic than management when it comes to certain elements pertaining to future growth--e.g., realizable revenue and/or cost synergies, as reflected in our projections. In fact, our analysis goes much deeper than EBITDA and examines the true cash flow characteristics of issuers.

We found that both EBITDA growth and deleveraging efforts fell materially short of the issuer's projections for the two years that we tracked companies' performance after transaction origination compared to projections made by the management at deal inception. Specifically, our findings showed that on average, actual reported net leverage was 2.9 turns higher than forecast for 2016, growing to 3.6 turns in 2017. The table below illustrates that the companies in the sample set missed substantially in projecting EBITDA and to a lesser extent, debt.

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