Imagine this: you are a private credit fund considering whether to finance a leveraged buyout. There are positive signs: the company is growing, market trends are positive, it has a strong management team, and the lending terms seem sensible. Everything initially looks great, but when you begin to analyse the company’s EBITDA (earnings before interest, tax, depreciation and amortisation), all is not quite as it seems. The figures have been significantly inflated to justify a higher quantum of debt, one that could be unsustainable if the market turns. This is not just a thought experiment – it is happening with alarming regularity. It is crucial that we guard against it.
The role of a private credit fund is to take risks on behalf of investors. Firms have always focused on assessing the performance of a company to find a sustainable financing package that both aids the company’s growth and is flexible enough to allow it to weather difficult market conditions. However, it is with increasing regularity that lenders are being asked to take on higher levels of risk based on EBITDA numbers that have been egregiously adjusted and bear little resemblance to reality.
While EBITDA is a well-understood and often-used metric to assess a company’s performance, it is not hard to see how it has become open to abuse. There are a number of subjective elements to its calculation; for example, companies are increasingly able to include pro-forma adjustments that inflate actual performance. It has become common for companies to adjust their EBITDA figures to include estimates relating to future performance and potential outcomes. This leads to a situation where the published EBITDA figure is an expression of what the company’s management team hopes will happen, rather than reflecting the actual status.
The type of adjustments included in EBITDA figures we see take into account the expected impact of past actions, such as increased revenues from recent price rises and savings from implemented restructuring measures. The current trends are to increasingly include the expected impact of actions not yet taken, such as proposed restructuring measures and stores that are planned but not yet open, or to include benefits which are expected to take longer to achieve, even several years into the future. The majority of pro-forma adjustments are, by definition, subjective or speculative in nature and depend on a number of variables as to whether they will ever become a reality.
There is a danger that blindly accepting such adjustments will lead private credit funds to take on higher risk than they realise. The company, too, will likely suffer, as it will be saddled with levels of debt that aren’t sustained by the real cash generation which could threaten its ability to operate. In a strong economy and a bullish market, where it is relatively easy to finance or refinance a company, such a situation may be manageable, but it could lead to unintended consequences when the market turns and the business environment is not as favourable.
What can lenders do?
First, when investing in a company, it is extremely important to understand what you are investing in and the industry in which it operates. This might seem like obvious advice, but it can be easily overlooked when you are being presented with favourable figures as part of a compelling proposition. However, if you are provided with an inflated EBITDA figure and take it at face value you are opening yourself and your investors up to potential problems.
At EQT we use the network of industrial advisors, along with the shared knowledge from owning similar companies across Europe for the last 25 years, to gain valuable insights on the issues affecting the industry, a company’s suppliers, customers or competitors, as well as the company itself. It is through this expert understanding of the sector that we are able to judge whether the EBITDA figure provided is a fair reflection of a business’s financial position.
It is vital to fully analyse a company’s financials, how the cost base works and, in particular, its cash flow. Cash flow is difficult to artificially increase and provides real insight into whether a business can meet its costs and its ability to withstand market turbulence. Ideally, a company will have positive and recurring cashflows in a non-cyclical industry, which indicate a healthy business that can service its debt over the long-term. Look also at the frequency of “non-recurring” add-backs in the historical adjusted EBITDA – if they are every year, it should tell you something!
Lastly, a good indicator of whether a company’s EBITDA is fair is to compare it with other businesses in the same sector. If you find that it is significantly higher than similarly-sized businesses, then it is possible that the EBITDA may never become reality and the risk of lending to the company is increased.
In the current market environment, with huge capital inflows and competition for deals, lenders must retain their discipline and take time to carry out thorough due diligence. Investors must stick to their core principles and be prepared to say “no”, even to a seemingly good investment. After all, sometimes the smartest investment is no investment at all.
Paul Johnson is a partner at fund manager EQT Credit in London.