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When The Credit Cycle Turns: The EBITDA Add-Back Fallacy

Looking For A More Realistic Picture

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

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.

Table 1

Company Projected vs Net Reported
-- EBITDA* -- -- Debt -- -- Leverage** --
2016 2017 2016 2017 2016 2017
% exceed proj. 6% 13% % exceed proj. 44% 25% % exceed proj. 16% 13%
% missed >=10% 78% 75% % missed >=10% 25% 59% % missed >=1x 72% 75%
% missed >=25% 56% 69% % missed >=25% 16% 31% % missed >=2x 50% 63%
% missed >=33.3% 50% 63% % missed >=33.3% 13% 31% % missed >=3x 38% 53%
% missed >=50% 13% 31% % missed >=50% 6% 16% % missed >=5x 19% 31%
Average miss 29% 34% Average miss 7% 19% Average miss 2.9x 3.6x
Median miss 33% 39% Median miss 1% 12% Median miss 2.1x 3.5x
*Company's projections are adjusted EBITDA. ** Leverage calculation based on average of debt to EBITDA of each company in sample.

It is our understanding that add-backs are an area of great concern to investors regarding borrower-friendly loan documentation, along with covenant-lite loans, incremental facilities, yield protection and restricted payments/unrestricted subsidiaries. The primary argument for the adjustments made by issuers/arrangers/sponsors is that they present a better picture of the company's future or run-rate profitability and thus a better picture of leverage and credit risk. The key questions are: Do add-backs help to present a more realistic picture of future earnings, leverage and credit risk and do companies typically hit their forecasts?

We believe the increased frequency and magnitude of add-backs can to some extent be attributed to the 2013 Interagency Guidance on Leveraged Lending (Leveraged Lending Guidance), which flag transactions leveraged at more than 6x EBITDA. Absent aggressive add-backs, rich transaction multiples coupled with the leverage cap would have made many transactions unattractive from an equity return perspective.

In addition to masking higher leverage, the spillover effects could increase event risk for loan investors as EBITDA adjustments also make their way into certain critical loan covenants that use EBITDA as the basis. This gives the borrower potentially more flexibility to (a) avoid tripping a maintenance covenant (even if only on the revolver), (b) make it easier to meet incurrence test and negative covenants tied to financial metrics that include the adjustments, and (c) increase the free and clear basket (increasingly prevalent) that is often tied to or equal to the initial management adjusted EBITDA.

The Evolution Of EBITDA Add-Backs

While EBITDA has been around for a long time, it became more widely used in the late 1980s and early 1990s when banks wanted to syndicate loans for cable companies. These companies, in the process of building out cable systems, had a voracious appetite for investment but did not generate free operating cash flow--the line item in the financials that is most indicative of a company's ability to repay debt.

EBITDA, at first, was signaled to indicate a company's ability to generate (gross) cash flow and, implicitly, service debt. Thus, a company with a debt-to-EBITDA ratio of 5x could repay the debt within a reasonable period since, it was argued, that working capital requirements were negligible and capital expenditures could be immediately scaled back to service debt. The banks (and other investors) seeking lending opportunities bought into the concept, and in hindsight did objectively well as the default rate among cable companies was relatively benign.

Over time, management adjusted EBITDA as a concept arose as a proxy for a company's future run-rate cash flow generation, post-acquisition or -divestiture or -merger. In these cases, transaction costs, a current expense, or expected cost savings (synergies) were added back to the reported EBITDA to create the management-adjusted EBITDA, which would serve as a better proxy of future (gross) cash flow.

Add-backs have been a growing component of EBITDA

As the leveraged finance market grew, so did the prominence of add-backs in the calculation of management-adjusted EBITDA. To quantify such impact, we focused in on a sample close to 50 large cap LBO and M&A transactions originated during 2015 that were rated by S&P Global Ratings, and for which we had detailed information on both management projections and management adjusted EBITDA reconciliation. We further broke down the sample based on the nature of the transactions (M&A versus LBO) as well as by credit ratings to look for meaningful differences.

Table 2

EBITDA Adjustment Breakdown
Average of total add-backs as % share of EBITDA reported by mgmt at origination
B+/B/B- 50.3%
BB+/BB/BB- 21.4%
Total 45.5%
LBO 47.3%
M&A 44.0%
Total 45.5%

Table 3

EBITDA Adjustment Breakdown
Avg % share of total add-backs Count Transaction Costs Restructuring Non-recurring operating Cost Savings / Synergies Mgmt Fee/ Exec Comp Other Adj
B+/B/B- 40 17.9% 11.5% 25.2% 19.7% 12.6% 13.1%
BB+/BB/BB- 8 8.4% 13.7% 6.2% 53.0% 10.5% 8.2%
Total 48 16.3% 11.9% 22.0% 25.3% 12.2% 12.3%
LBO 22 17.2% 11.7% 33.5% 15.1% 14.9% 7.6%
M&A 26 15.5% 12.0% 12.3% 33.9% 10.0% 16.3%
Total 48 16.3% 11.9% 22.0% 25.3% 12.2% 12.3%
Transaction costs included acquisition-related costs and merger-related expenses. Restructuring costs include such items as severance costs and losses from closed operations. Nonrecurring operating costs included one-time expenses. Typical one-time expenses that expanded to become reoccurring in subsequent years were excluded and put in another category, typically in "Other". Management fees and executive compensation costs included stock-based compensation. "Other" became an extensive category, due to specific companies' niche add-backs included in their projections. Some common adjustments included in "Other" are deferred income costs, inventory adjustments, impairment of intangible assets, undisclosed pro forma adjustments, and other. Note that we generally treat restructuring charges as operating costs in our calculation of EBITDA per paragraph 155 of the Ratio & Adjustments criteria, “consistent with their treatment in the cash flow statement as operating activities. Moreover, most companies need to restructure at some point, as the global economy is constantly evolving and businesses alter their operations to remain competitive and viable.”

Tables 2 and 3 sort the general add-back adjustments into six broad categories (transaction costs, restructuring costs, nonrecurring operating costs, synergies, management fees/executive compensation costs, and other). On the aggregate level, add-backs inflated projected EBITDA by an average of 45%. Synergies/cost savings was the largest component, accounting for over 25% of total add-backs.

Management Projections: A Picture That Is Just Too Rosy

Next, we assessed the validity and accuracy of these add-backs that companies expected to achieve. Again, given limited disclosure and the difficulty in parsing out the specific components of EBITDA add-backs and whether they were eventually realized, we instead compared management adjusted EBITDA at deal inception with the actual reported.

Specifically, we compiled management leverage projections made in 2015 for companies in the sample. We then looked at the companies' actual earnings, debt and leverage for the years 2016 and 2017, and compared them to the initial management projection made in 2015. To remove distortion arising from subsequent transformative events, we eliminated companies that underwent material transactions in 2016 and 2017. Although doing so reduced our sample size to 32 from 48, it enabled us to cleanly track the reported EBITDA, debt, and leverage in 2016 and 2017 versus what was projected for these companies in 2015, as there was no noise to earnings and debt arising out of additional debt issuances or subsequent acquisitions large enough to require additional financing.

Stagnant EBITDA growth...

If the companies in our sample set realized their projected EBITDA (and add-backs) over our two-year test period, we would expect to see a convergence between management projected and reported EBITDA as one-time items fall away and the company realizes expected growth and synergies. Conversely, a divergence in the numbers is indicative of unmaterialized growth projections, operating challenges and unrealized synergies.

We note that there is a clear positive bias among management projections. Charts 1 and 2 show that our sample set reported EBITDA 29% below projected during 2016, growing to 34% in 2017. For 2016, 56% of the companies reported EBITDA at least 25% below projections, increasing to 69% during 2017. The growing divergence hints at limited synergy extractions in year two, resulting in a more pronounced difference between forecast and actual EBITDA. Key takeaways are that management projections were generally off, almost universally overstated, and get less reliable over time (in the case of our study, just two years from deal inception).

Chart 1


Table 4

Co. Projected vs Actual Reported
2016 2017
Average miss 28.9% 33.6%
Median miss 32.6% 39.0%
Highest miss 83.4% 73.6%
Total count 32 32
# exceed proj. 2 4
% exceed proj. 6.3% 12.5%
# missed >=10% 25 24
% missed >=10% 78.1% 75.0%
# missed >=25% 18 22
% missed >=25% 56.3% 68.8%
# missed >=33.3% 16 20
% missed >=33.3% 50.0% 62.5%
# missed >=50% 4 10
% missed >=50% 12.5% 31.3%
...Coupled with failure to meaningfully deleverage…

We also looked at projected versus reported net debt as a contributor to disparity or convergence in leverage. Virtually all issuers present a deleveraging story at deal inception with surplus cash swept to reduce debt in management projections. Across our sample set, companies under-projected outstanding debt by an average of 7% in 2016 and 19% in 2017; 16% of the companies under-projected debt outstanding at year-end 2016 by at least 25%, increasing to 31% for 2017.

The intent of companies on the application of surplus cash to pay down debt appears to be infrequently executed: we noticed that companies rarely, if ever, pay down debt to the extent indicated in marketing materials at deal inception. However, for comparability, we have netted reported cash balances against reported debt for the purpose of computing both debt and leverage divergence below.

Chart 2


Table 5

Co. Projected vs Net Reported
2016 2017
Average miss 6.9% 19.5%
Median miss 1.5% 12.2%
Highest miss 100.6% 119.1%
Total count 32 32
# exceed proj. 14 8
% exceed proj. 43.8% 25.0%
# missed >=10% 8 19
% missed >=10% 25.0% 59.4%
# missed >=25% 5 10
% missed >=25% 15.6% 31.3%
# missed >=33.3% 4 10
% missed >=33.3% 12.5% 31.3%
# missed >=50% 2 5
% missed >=50% 6.3% 15.6%
…Leading to actual leverage far above projections

As a result, there is a material discrepancy between projected leverage and reported leverage across the aggregate data set. On both ends, we see a company's projections become increasingly aspirational, building a significant leverage cushion and presenting a case that is not necessarily representative of actual credit realities. Chart 3 illustrates that, on average, companies under-projected leverage by 2.9 turns for calendar year 2016, increasing to 3.7 turns in 2017.

Chart 3


Table 6

Co. Projected vs Net Reported
2016 2017
Average miss 2.9x 3.6x
Median miss 2.1x 3.5x
Highest miss 20.9x 10.0x
Total count 32 32
# exceed proj. 5 4
% exceed proj. 15.6% 12.5%
# missed >=1x 23 24
% missed >=1x 71.9% 75.0%
# missed >=2x 16 20
% missed >=2x 50.0% 62.5%
# missed >=3x 12 17
% missed >=3x 37.5% 53.1%
# missed >=5x 6 10
% missed >=5x 18.8% 31.3%
Projected Leverage (avg.) 4.2x 3.3x
Actual Leverage (avg.) 7.1x 7.0x
Projected Leverage (med.) 4.2x 3.4x
Actual Leverage (med.) 6.1x 6.5x

'BB' Versus 'B' Rated Companies

When looking at 'B' vs. 'BB' category credits, 'B' category credit EBITDA contained a greater percentage of add-backs than 'BB' category credits. Overall for 'B' companies, add-backs represented over 50% of total management adjusted EBITDA vs. about 21% for 'BB' category credits.

As expected, the 'BB' category credits performed significantly better than the 'B' category credits in projecting earnings. We believe this is likely attributable to the fact that add-backs for 'BB' category credits were materially lower than for 'B' category credits, so the projections were less reliant on achieving pro forma synergies and other future benefits. Further, the need for add-backs to make a deal appear attractive to the market is likely lower since pro forma leverage is typically lower for 'BB' category credits, so it is possible that the add-backs were less aggressive or aspirational. Additionally, we could offer an intuitive view that the lower-rated credits tend to be smaller and have higher volatility in earnings making the projection a more difficult exercise.

'B' category credits reported leverage 3.4 turns higher than projected in 2016; with the gap widening to 4.2 turns in 2017. Projected EBITDA was 41% greater than reported during 2016 and 58% higher in 2017. Whereas 'B' category credits demonstrated a widening gap in projected vs. reported, 'BB' category credits had a demonstratively smaller gap three-tenths of a turn for 2016, growing modestly to seven-tenths of a turn in 2017. This analysis further reinforces the significant credit disparity between 'B' and 'BB' credits.

Chart 4


LBO Versus M&A Transactions

LBO and M&A transactions are comparable in the aggregate amount of add-backs as a percentage of aggregate management-adjusted EBITDA. However, the distribution of add-backs differs. As one would expect, M&A transactions showed above-average synergy add-backs as these are often a selling point of the transaction, comprising about 34% of add-backs.

There is not a pronounced difference in the quality of management projections between M&A and LBO transactions; both proved unreliable with the discrepancy between management projected and reported ranging between 2.7-3.8 turns across both universes.

Chart 5


Our study led us to several conclusions: 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 (dividends, debt and lien allowances, etc.).

When the credit cycle turns, it will be interesting to observe the default and recovery performance of entities with substantial EBITDA add-backs as the legitimacy of several add-backs comes into question and suggests that the implied pro forma leverage for such deals is a misleading indicator of credit risk.

[1] Standard & Poor's defines EBITDA as revenue minus operating expenses plus depreciation and amortization (including noncurrent asset impairment and impairment reversals). We include cash dividends received from investments accounted for under the equity method, and exclude the company's share of these investees' profits. This definition generally adheres to what EBITDA stands for: earnings before interest, taxes, depreciation, and amortization. However, it also excludes certain other income statement activity that we view as nonoperating.

This report does not constitute a rating action.

Primary Credit Analysts:Olen Honeyman, New York (1) 212-438-4031;
Steve H Wilkinson, CFA, New York (1) 212-438-5093;
Secondary Contacts:Hanna Zhang, New York (1) 212-438-8288;
Greg T Maddock, New York (1) 212-438-7205;
Analytical Manager:Ramki Muthukrishnan, New York (1) 212-438-1384;

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