EBITDA adjustments, known as add-backs, have been a hot topic in the global leveraged loan and high-yield bond markets recently, as private equity firms undertaking large M&A deals are increasingly relying on this technique for financing.

These adjustments — under which a private equity firm or acquiring entity can add an expense back to profits, significantly improving a transaction's pro forma numbers — are not without controversy. Debt investors complain vociferously that, via add-backs, actual risk is being masked, as borrower leverage down the road will be understated if the rosy earnings numbers being forecast do not actually come to pass.

But just how much risk do these adjustments add? If a transaction's debt-to-EBITDA ratio has crept higher based on adjusted EBITDA alone, how much riskier are these deals if EBITDA adjustments are stripped out?

LCD analyzed U.S. M&A-related leveraged-loan transactions — buyouts, sponsored and corporate M&A deals — comparing adjusted and unadjusted pro forma EBITDA. The analysis considered EBITDA first with synergies, then without.

Synergies, or cost savings, have become a key issue in the current, highly levered market because borrowers and lenders can have very different views as to whether, when, and to what degree synergies can be achieved. Synergies are also a major component of the overall add-back picture. Recent analysis by S&P Global, looking at deals completed in 2015, found that synergies accounted for 34% of all add-back calculations. Other elements of EBITDA add-backs include non-recurring operating costs, management fees and other adjustments. These help to illustrate the borrower's post-transaction cash flows, and they do not usually influence long-term financials.

The above chart details pro forma leverage of U.S. M&A-related deals undertaken in 2018, with and without synergies. Transactions in the red and blue quadrants represent the riskiest deals, those with a pro forma debt-to-EBITDA multiple of 6x or higher, excluding synergies. Deals in the red quadrant remained above the 6x line even after synergies were included, with most remaining in the 6x to 7x zone, illustrating just how aggressive some of today's transactions are. The deals in the blue quadrant moved below the 6x line due to synergies, with most falling into a 5.5x to 6x zone, which is within a half-turn of the average adjusted leverage for all M&A deals tracked by LCD so far this year (5.5x).

In short: If the borrower achieves the anticipated synergies, these transactions are slightly more aggressive than average. If not, the risk rises significantly.

Looking at the historical trend, it is notable that the unadjusted leverage ratios are not only higher than the adjusted ratios, but they have a steeper curve than leverage ratios that include synergies. Without synergies, the average debt/EBITDA ratio of 2018 deals is currently 5.8x — a third of a turn higher than the adjusted ratio of 5.5x.

The gap between adjusted and unadjusted leverage has widened over the past five years as synergies have become an embedded part of financial estimates.

The increase over the last decade is even more drastic when looking at leverage through first-lien term debt. Year-to-date, M&A transactions were levered at 4.5x EBITDA with synergies and 4.7x EBITDA without synergies. In contrast, these metrics stood at 3.7x and 3.8x at the peak of the last cycle, in 2007.

Leverage has risen this year as M&A transactions increased in size. Looking at the total amount of loans and bonds used to fund buyouts and M&A, the average debt size has reached an 11-year high, at $950 million so far in 2018, up from around $890 million in the prior three years. For reference, the average stood at $954 million in 2007. This growth came exclusively via the loan market, with the average loan portion of the financing reaching an all-time high, at $872 million, while the high-yield bond portion fell to a nine-year low in 2018, at $77.3 million.

With the bigger deals, M&A has been the primary driver of U.S. loan issuance in 2018, with volume already surpassing the post-crisis high set last year. With two months left in the year, U.S. loan volume to fund buyouts and M&A totaled $302 billion as of Oct. 16, edging out 2017, at $295 billion, and every other full-year figure since the $333 billion in 2007.

With the increase in jumbo M&A transactions, the share of aggressively levered deals has risen to record levels this year. Some 40% had a pro forma debt/EBITDA ratio of 6x or higher, based on adjusted numbers, or 46% based on unadjusted EBITDA. The 6x leverage figure — flagged by federal agencies in 2013 as raising concerns — remains notable, market players say, despite clarification last month that the guidance is not technically a rule.

In 2017, the share of deals levered at 6x or higher was 33% with synergies and 43% without synergies.

Moving further up the leverage spectrum, 8% of transactions had pro forma debt-to-EBITDA ratios of 7x or higher in 2018, including synergies, up from 5% in 2017 and on par with 2014. While this metric has risen in recent years, it remains far below the 2007 record of 17%.

Assuming, however, that the expected synergies are not achieved, the share of M&A transactions levered at 7x or higher increases to 17% this year, up from 14% in 2017 and just below the 2007 record of 19%.

These figures suggest that the number of aggressively levered borrowers using synergies in their pro forma financials has risen in recent years. Thus far in 2018, LCD has tracked close to 130 M&A transactions in which pro forma EBITDA was adjusted for synergies and cost savings. More than half — 51% — had an unadjusted leverage multiple of 6x or higher, while 25% were in the 7x-or-higher zone. Three years ago, 40% of deals with synergies-related adjustments came from the 6x-or-higher zone and just 7% were at 7x or higher.

Market take

EBITDA adjustments have been a fact of life in the global leveraged-loan market for years. Investors, however, remain wary, and some argue that the adjustments are becoming harder to realize and are increasingly esoteric. While some on the buy side say they strip synergies out when modeling the business, there is no doubt that the price the debt has been sold at assumes that the synergies have been realized.

Along with this initial credit risk, the specter of adjustments can follow an issue into the secondary, adding trading risk. As one investor explained, the buy side regularly wonders whether those first earnings numbers will align with the metrics on display at the deal's launch. This, investors say, should merit a trading premium, though that often is not the case.

LCD is an offering of S&P Global Market Intelligence. S&P Global Market Intelligence and S&P Global Ratings are owned by S&P Global Inc.