Mathematical Sophistry: Aggressive EBITDA Adjustments Raise Concerns Among Creditors

Ahead of the upcoming 5th Annual LPGP Private Debt Connect conference in New York, Murray Devine Managing Director Mark Emrich explores why lenders are so concerned about the creativity being applied to pro-forma EBITDA calculations today.

Double-digit entry multiples used to provoke a sense of uneasiness, but as the market enters its seventh straight year in which the median buyout multiple exceeds 10x EBITDA, high valuations have simply become the norm. If there’s an area sparking a sense of anxiety, however, it’s not so much the purchase prices, themselves, but rather the adjustments to EBITDA that underpins the multiples being paid. Lenders, in particular, are often caught in the middle.

From a 20,000 foot view, the deal market certainly appears quite healthy. Yes, valuations have hovered near historic highs, but the economic outlook continues to provide confidence. GDP growth, in turn, has translated into earnings and margin expansion, which allows PE-backed companies to very quickly grow into rich entry multiples. Moreover, the holding periods of PE portfolio companies continues to narrow, reducing the risk to investors, while the deals, themselves, are being funded with more equity than previous eras. For context, debt comprised approximately 55% of the median LBO purchase price last year, representing a cushion of approximately 400 basis points compared to the leverage in deals completed a decade earlier.

In earlier eras, even casual observers could spot the late-cycle tendencies. LBOs in which the equity component comprised less than 10% of the capital structure, for instance, were a soft target for critics. Today, egregious behavior is taking on other, less obvious forms. Covenant-lite loans, for instance, seem to be trending ever “lighter,” while moving higher in the capital structure as senior-stretch financing blurs the lines of subordination. Lenders, meanwhile, have begun scrutinizing instances of “leakage,” in which the backstops that informed their underwriting evanesce. This risk, in particular, gained widespread attention after PetSmart’s lenders cried foul last year over an equity transfer involving the company’s Chewy.com subsidiary. This, of course, is on top of increasing aggression seen in EBITDA adjustments that has both buyers and lenders concerned.

To be sure, pro-forma estimates have always been a critical component of the M&A calculus. These assumptions – acknowledging the flexibility required in underwriting – are critical to better understand trends in company fundamentals and parse between fixed costs and one-time or extraordinary items. Lenders, in particular, will utilize adjustments to gain clarity around leverage ratios, while pro-forma calculations help acquirers better appreciate unseen revenue or cost synergies that can provide a pricing advantage in a competitive auction.

None of this, on its own, is cause for concern. Increasingly, though, dealmakers are sounding the alarm about how aggressive these add backs have become. Among sponsors, Bain Capital’s Jonathan Lavine equated it to tweaking a scale. “I’m 5’8, but [if] I change the scale [I can] make myself 6’2 on a pro forma basis,” he told the Financial Times. The risk, he further spelled out, becomes evident if company growth doesn’t match the assumptions being made.

Among lenders, TCW’s Drew Sweeney also called attention to aggressive adjustments he’s seeing in the market. He cited one deal in which the “marketed” EBITDA was 90% greater than the actual bottom line — math that he remarked was “borderline absurd.”

The growing risk is also on the radars of LPs. In outlining its 2019 PE strategy, the Oregon State Treasury, for instance, observed that aggressive adjustments have “emboldened sellers” to bring assets to market earlier than they otherwise would.

And from the perspective of a valuation specialist, we’re increasingly seeing instances of aggressive add backs in our work, particularly in solvency opinion engagements. The adjustments don’t just create an added layer of complexity, they can also overlook the costs required to achieve certain assumptions. If a company plans to close an unprofitable office and seeks to strip the liabilities from their pro-forma run-rate calculations, are they also factoring in the costs to break the lease or fund severance packages for affected employees? 

The complexity created for all involved also shouldn’t be understated. In conversations with one CFO at a private equity firm, they cited a recent auction in which the target tried to push through over 200 different adjustments. Anecdotally, deal pros are noting that this has led to an uptick in broken deals. As the Oregon State Treasury observed in its presentation, the growing propensity for stalled processes stems from a market that has found “its threshold” for these risks.

S&P Global, in trying to quantify the impact of adjustments, analyzed leveraged loans involving deals with debt exceeding 7x EBITDA – a threshold that typically signifies added risk. S&P noted that when looking at pro-forma numbers, deals with debt above 7x accounted for just 8% of all M&A activity utilizing leveraged loans. When S&P stripped out the synergy assumptions, however, the proportion of “unadjusted” deals with debt multiples exceeding 7x more than doubled to 17%.

In some cases, the aggression may stem from the sellers themselves. Management teams or business owners, recognizing a flush M&A market, are rushing to take advantage. In the process, and in light of the pace of activity today, they’re trying to impose certain assumptions that in tougher times would garner more scrutiny, or be negotiated out. Sometimes, too, the bankers marketing the deal, try to close the gap separating seller and buyer expectations by adding back ‘non-recurring’ expenses that would otherwise be disallowed.

The credit market, though, bears much of the brunt of this added risk. This is particularly the case as protections get whittled away and given the increasing threat of leakage, in which assets that may have served as the security for a given loan are transferred out of creditors’ purview. But the biggest risk is that they’re underwriting against assumptions that only consider best-case scenarios.

Even when stress-tested or downside scenarios are factored into lenders’ underwriting it can equate to an increase of a full turn or more in the total amount of leverage that supports a given transaction. And if debt levels drift from 5x to 6x leverage, thanks to creative add backs, it can leave little if any cushion for hiccups in company performance. This is why in such a competitive market, lenders aren’t just being asked to absorb high valuations or fewer protections; they’re effectively being asked to look the other way when underwriting against overly optimistic assumptions.

While asset owners and institutional investors are eager to allocate to private credit managers in the current environment, they’re also increasingly scrutinizing underwriting processes and remain attentive to the risks. Just as they want managers to demonstrate reliable channels of deal flow and sourcing capabilities, they’re also seeking discriminating managers with a track record passing on deals they find marginal.

The other risk, one being overlooked by sellers and their bankers, is that overly aggressive adjustments today could strike at their credibility down the road. It’s no different than acquirers who have developed a reputation for retrading on their initial bids as a way to sidestep a competitive auction.

Most importantly, though, is that while observers may gain comfort in the economy and top- and bottom-line growth projections, creativity around EBITDA adjustments creates a blind spot that threatens to take investors by surprise.

Mark Emrich leads business development for Murray Devine in the New York, serving private equity, private debt, hedge fund, and real estate clients in addition to banks, law firms, insurance companies and other financial intermediaries.