In part two of our four-part blog series on cov-lite lending and beyond, we take a closer look at EBITDA adjustments – a financial-metric ‘modification’ that has become commonplace.
EBITDA adjustments in themselves are nothing new in leveraged finance. Indeed, they are a normal part of the process of evaluating the risk of a buyout loan. Typically, when a company is being acquired by a private equity sponsor, there is a growth plan that will involve acquisitions – some of which may have been already identified – or a streamlining plan that will involve cost-cutting and divestments. When this is clearly explained and researched, some ‘credit’ may be afforded, upfront, by lenders and deemed acceptable. This would then be considered an appropriate ‘adjusted EBITDA’.
However, one of the more pernicious features of the loan market – at this late point in the cycle – is the way in which traditional reasons for adjustment are being stretched by some aggressive management teams and owners. This is even more the case in the high yield bond market. The principal area of concern relates to future earnings growth and purported cost-savings.
When presenting its financial structure, a company will typically show a higher EBITDA than its actual reported earnings in order to convey a sense of the true position of the company, now that it is under new ownership. It will also (legitimately) take credit for positive events that may have happened part-way through the prior year or remove a cost that will disappear directly as a result of the takeover.
Typical, traditional reasons for EBITDA adjustment are:
- Acquisitions made part-way the prior financial year – contribution of full-year earnings;
- Royalty costs to a former parent terminated on divisional disposal;
- Merger synergies – eg savings from the closure of a second head office, procurement benefits arising from greater size and purchasing power;
- One-off costs pertaining to the buyout itself;
Where things become trickier is in the forecasting of future synergies and earnings growth: ‘profoma’ adjusted EBITDA. These need careful consideration and must be looked at with a sceptical eye. We use our extensive analysts’ experience of the asset class, industrial sectors and sponsors to discount anything that feels questionable. We aim to come up with an ‘M&G EBITDA’ with which we feel comfortable and against which we shall judge opening leverage – an integral part of ascribing an M&G rating to any loan. The adding-back of non-recurring items that allow borrowers to take on more leverage can be another area where cynicism is required, ‘exceptional items’ sometimes being anything but one-off.
Things we watch out for:
- Indefensible synergies;
- Synergies to be extracted after more than one year;
- Brand new management/owners with no prior record to defend credibility of adjustments;
- Third (or fourth) time buyout where yet more cost-savings are promised;
- Requests for credit to be given for as yet unidentified acquisitions;
In terms of measuring the current state of the market:
S&P issued a research piece1, in October, which stated that average leverage between EBITDA, adjusted and unadjusted for synergies, in US M&A-related leveraged buyouts (LBOs) issued in the year to date deviated by one third of a turn of leverage (5.8x versus 5.5x).
For Europe, S&P did not publish equivalent statistics, but Moody’s2 attempted to quantify the EBTIDA adjustments made across the European leveraged finance universe (ie loans and high yield bonds) in June 2018. Their conclusion was that EBITDA adjustments accounted for c.14% of earnings-change, on average, in 2017 versus 10% in 2016.
Moody’s also noted that the achievement of those proforma earnings was far more common in loan issuers than in bond issuers (perhaps owing to the preponderance of ‘professional’ financial owners ie private equity sponsors driving management and operations more assertively). New loan issuers achieved 81% of their adjustments within a year, reported the rating agency, compared with a 53% success rate for bond issuers.
Last, Moody’s observed that the incidence of not achieving EBITDA adjustments was higher in smaller companies (those with debt between €250-500 million) than larger ones. For smaller companies, Moody’s observed that the EBITDA at risk of not being achieved amounted to c. 5% (versus 0% to 2% for larger corporate issuers).
Other considerations pertinent to loans:
Loan documentation would typically restrict the future period that can be considered for synergies to 12-18 months. Anything longer would need exceptional justification to pass our sniff-test.
CFOs are often required to sign off that third-party due diligence has been conducted to defend any sizeable adjustments;
European private-side lenders will usually receive due diligence reports, including a ‘quality of earnings’ analysis to bridge reported and adjusted EBITDA – this is detailed analysis of each item with associated verification from a third party and such information is not forthcoming in the US loan market;
As far as lending at M&G is concerned, we stick to our traditional method of investing: focusing on the larger companies in the European LBO universe, staying near-exclusively senior and subjecting our issuers to rigorous stress-testing. Our decline rate on loan opportunities remains as high as it has always been (c.66%) as further demonstration of our selectiveness. In this environment, we value ever more the ability to lend from the private-side, being privy to greater and more frequent information, formally and informally, as befits a long-standing, large, relationship-focused and well-resourced lender.
1 S&P Global Market Intelligence, “EBITDA adjustments: Leverage of M&A deals, before/after synergies”, 18 October 2018
2 Moody’s Investor Service, “Speculative-grade non-financial corporates – EMEA”, 27 June 2018
In part three of this blog series, we examine loan default risk and recoveries in the era of cov-lite lending.
The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested.