Mark Darley, head of the European law banking practice at Skadden, Arps, Slate, Meagher & Flom, raised some hearty laughs at Xtract Research’s European Covenant Trends event this year with his paraphrase of the opening to Charles Dickens’ A Tale of Two Cities: “It was the best of terms, it was the worst of terms, it was the age of wisdom, it was the age of foolishness …”
The juxtapositions may have had attendees shifting nervously in their seats, since they represented an obvious parallel with the experiences of borrowers and investors in the leveraged loan market. They also applied to the smaller mainstream private debt market, which adopts at least some of the practices introduced at the larger end.
For borrowers, these truly are the best of times. But for investors, they may well be the worst.
Until recently, the talking point was the resurgence of covenant-lite deals, which had last dominated prior to the global financial crisis. But since these are now considered the norm for larger deals – accounting for around 80 percent of new European acquisition finance transactions by the end of last year, according to data provider Debt Explained – they no longer have novelty value. Hence, attention has shifted to other aspects of deal agreements – specifically to the EBITDA addback, arguably today’s most discussed and controversial deal term.
It is essentially a sum of money “added back” to the profits of a company. Among the reasons for doing so would be the synergy gains that would supposedly arise from an acquisition – the argument being that adding back those gains, or at least some of them, provides a more realistic picture of profitability.
One of the most controversial aspects of addbacks, which are often referred to as “adjustments”, is that an inflated EBITDA figure in effect enables a company to disguise the amount of leverage it is taking on. This is because total leverage is normally expressed as a multiple of EBITDA.
When an observer looks at the leverage in a deal as a multiple of EBITDA, they may have no notion of how addbacks have contributed to that figure. What appears to be a relatively normal or conservative leverage figure may in fact be based on fragile assumptions.
If these addbacks were only occasional and reasonable in their scope, it is fair to assume they would not be such a hot topic. Instead, they are becoming more frequent and are sweeping aside previously accepted boundaries.
In what is commonly dubbed a ‘borrowers’ market’, addbacks are seen by many as the most egregious example of how some investors will accept any demand from a borrower as the price of participation in a highly liquid market.
“Traditionally, the parameters of such addbacks were fairly well regulated,” says Christine Tadros, head of European research at Xtract Research. “For example, you always used to have a cap [on the amount that could be added back], a look-forward limit [a period within which the projected synergies must be realised], and they could only be used specifically in the case of acquisitions.”
All of these limitations are being eaten away, says Tadros. Xtract data show that in 33 percent of loans studied projected synergy addbacks were uncapped, meaning there was no limit on the “potential synergies” that could be added back to the EBITDA figure.
This sounds suspiciously like a free-for-all, but some observers are keen to stress that investors are not totally impassive. Brad Wilson, a director in HSBC’s leveraged and acquisition finance team, believes that when proposed terms look especially disadvantageous, investors can fight back – and that they have done so on issuances, such as those from AkzoNobel and TDC Group.
Speaking at the Xtract event, he said: “There has been pushback on areas like uncapped synergies, and this has fed through into the final terms.”
Wilson added that not all synergies are viewed in the same way, and investors may regard some as reasonable. One such synergy would be cost savings that are rapidly realisable – with UK broadband provider Talk Talk’s relocation of its headquarters from London to Salford mentioned as an example.
Another more general example would be an educational institution with visible, contracted future revenues from school fees. In other words, the reasonableness or otherwise of addbacks can be business- or sector-specific.
But while some addbacks may be justifiable, there are others that have LPs shaking their heads in disbelief. Mikael Huldt, head of alternative investments at Stockholm-based AFA Insurance, relates one such case: “I have heard of one borrower who tried to get addbacks based on any and all Brexit-related costs and losses of sales. They were attributing their lower sales to Brexit, and claiming that the sales they would have got had it not been for Brexit should be added to the EBITDA figure. Some borrowers are trying to build in as much flexibility as they can.”
As an allocator to both private equity and private debt strategies, Huldt says AFA “sees it from both sides” in cases where the borrower is a private equity-backed firm and the lender is a private debt firm. He is well acquainted with the ‘spin’ from the private equity side: “We see the graphs that show prices are frothy in private equity but that equity cushions are much higher and that, therefore, we should be more confident. Leverage levels are not really that high and the sponsor has put more skin in the game, so the argument goes.
“That’s all well and good, but because of EBITDA addbacks we think leverage may be understated by as much as 40 percent in the US and maybe 15-20 percent in Europe, and that’s a huge cause for concern. It could mean we’re actually in a very scary place.”
As in Europe, the US is seeing plenty of examples of questionable addback practice. “As quality of earnings have become normal course on M&A transactions, you’re seeing an increase in instances where more adjustments are being presented,” says Richard Forgione, managing director at investment bank Houlihan Lokey. “Sellers are getting more creative, especially when there’s a story that needs to be told, such as disruption to the business.”
“Anything deemed non-recurring or non-core is typically acceptable to both sides as an addback,” he explains, noting that this can include stock compensation, severance, board compensation and transaction fees. “The more egregious ones are addbacks that take into account new product offerings or new business ventures where maybe only a few months of data is available.”
‘Hope is not a good thesis’
Among the less realistic requests is to take into account the opening of a new location for a store or restaurant. The borrower may want credit for future profits and to add back opening expenses. Questions then focus on the location’s assumed run rate and whether the borrower has successfully completed similar efforts before.
One credit manager says that companies, particularly retail and restaurant businesses, are securing credit for new locations. Non-retail companies, such as healthcare providers with bricks-and-mortar locations, are also making use of addbacks in this way.
However, the manager also says that companies rarely achieve all their EBITDA addback aspirations, and that it is “concerning” to see people buying into the hype surrounding all proposed adjustments. The source adds that many lenders give borrowers “full credit” for those new locations, and that more prudent lenders will only agree to include newer outposts that are already open. Requests have gone from newly opened stores to those that are two to six months away from opening, which the manager describes as “ridiculous”.
Among other examples the source has encountered are weather adjustments. If a business has had its operations disrupted because of a hurricane, say, it might try to get those lost earnings added back in. The source also saw a manufacturing business try to count potential profits lost as a result of operational mismanagement.
“You’re maxing out leverage or purchase price based on a hope, and hope is not a good investment thesis,” the lender says. However, some forward-looking addbacks can be legitimate and reasonable. “There’s some that are grey but provable,” a market source tells PDI. One example is a company getting credit for renegotiating contracts for purchasing supplies because it has just completed an acquisition that gives it more buying power.
Yet there is caution around what might be deemed EBITDA ‘add-forwards’.
“The challenge for me is when a seller represents all these things and doesn’t have support,” says Forgione. “That’s where I get more concerned. For the most part, it comes down to having supportable evidence. Are the estimates pretty loose? Is it really based on management’s judgment [rather than being] data-driven? Then it’s less supportable and usually not accepted.”
If it gets to the point of what some managers have labelled “fake EBITDA”, GPs might think about only using an EBITDA multiple as a secondary tool when it comes to valuing a business.
“If you have to make a lot of historical changes, you might apply a discounted cashflow [as a primary method] and use the EBITDA multiple as a secondary tool,” says Charles Sapnas, managing director of Valuation Research. “The more adjustments you have to make, the more questionable it is that historical EBITDA is the best valuation metric.”
Sources tell PDI that the use of addbacks will vary based on how large or small the portfolio company is.
“EBITDA addbacks are a real problem,” says Stephen Nesbitt, chief executive at investment advisory firm Cliffwater. “They potentially undermine the whole concept of security. Fortunately, it looks to be contained and correlated to borrower size.”
He says it is a “serious issue” in the broadly syndicated and upper mid-market, adding that the core mid-market and lower mid-markets have less of a problem. However, one credit manager noted that there is “continued pressure” on the core mid-market as a result of what is occurring elsewhere, so things could change.
“Addbacks are more common now than they were before,” says Gary Creem, partner at law firm Proskauer. “I think the negotiation is around how expansive they should be. They’re more expansive now than they were 10 years ago. I think it reflects a more competitive environment.”
Although EBITDA addbacks may be more permissible today than in years past, each segment of the market has different dynamics. On the whole, says Creem, the larger the company and the bigger the deal, the greater latitude a borrower will be given.
“The middle market is so opaque that it’s difficult for many to know how often this is happening,” says Cliffwater vice-president Jeffrey Topor. “You really have no idea unless you’re doing deep due diligence, digging into investment committee memos. Aggressive [addbacks] may be getting done, but you’re not going to see the consequences of this for years.”
Timothy Nest, a managing director in the private credit group at investment consulting firm Aksia, says: “From my vantage point, a solid economy, continued capital inflows to lending strategies and high velocity of refinancings are covering potential credit issues. We’d expect that once there is some weakness in business performance and deals get extended, covenant and cashflow issues may start to proliferate as more aggressive addbacks around expected synergies or cost savings do not materialise as anticipated.”
The drive for cost savings is where some of the bolder terms are coming from. “That’s where companies take advantage of adding back a significant amount of EBITDA,” says Joshua Clark, a leveraged finance analyst at Fitch Ratings. “The most egregious thing we see is lack of a cap on the addback for synergies and cost savings.”
The credit manager who noted the addback for hurricanes also saw a deal with a media company that suggested adding back more than $600 million in cost savings, including $125 million for infrastructure virtualisation. The requested adjustments took the company from an EBITDA of $1.9 billion to $2.5 billion.
This manager says borrowers are also beginning to push the envelope when it comes to the timeframes associated with addbacks. Portfolio companies previously sought 18-24 months to achieve the stated adjustments.
Now, some are striving for the same timeline, but rather than realising those addbacks, the borrowers only need to take action within the timeline. There is no cap on the actual amount of time in which they need to realise the synergies.
LPs have, for the most part, become more sophisticated in their approach to private debt over the years. They have progressed from asking managers to explain how the asset class works and their strategies within it, to questions about more specific matters such as deal terms. Addbacks are something that investors and their advisors have become more attuned to.
“One of the top risks related to direct lending that we’ve been stressing to clients is the aggressive use of EBITDA adjustments in many sponsor transactions, particularly as you go upmarket,” Aksia’s Nest says. “There are ramifications that an inflated measure of EBITDA can have – whether it be on the quality of covenants, the ability of a business to incur additional indebtedness, credibility of valuations and GP track records, along with the path of future recoveries.”
One credit manager says some LPs view the asset class through the prism of market share: the larger and more prominent the credit firm, the better the deal opportunities.
However, another source says those firms tend to participate in larger deals, which have some of the loosest documentation. This source points out that if LPs are concerned about having the right security, they would be better off targeting managers that invest in smaller deals.
“When we look at the deterioration of underwriting standards, there are the obvious things like upward leverage pressure and yield compression,” says Aksia’s head of credit strategies, Patrick Adelsbach. “The things that lie a bit beneath the surface generally fall into three camps. First, EBITDA addbacks – you’re making a riskier loan than it looks on paper. Second is the credit documentation itself, including details of the covenant packages. If trouble comes, what kind of controls do you have? And third is the quality of the company itself.”
Addbacks are more likely to delay a default because of the inherent latitude they give borrowers. A major impact of addbacks arises from how EBITDA factors into the loan’s covenants. A more permissive EBITDA definition could allow a company to incur more debt – be it secured or otherwise – and make more restricted payments, such as dividends. Both circumstances would dilute potential recoveries for lenders – with more debt to contend with or cash leaking through to the shareholders before reaching the lenders.
As Judah Gross, a leveraged finance analyst at Fitch Ratings, explains: “If something else triggers a default down the line, the lenders can be affected because of all these addbacks.”
Back in Europe, Trevor Castledine, former head of the credit strategy at the UK’s Local Pensions Partnership, says he had a “very straightforward view” of addbacks as an LP.
“No manager that allowed that sort of thing would get our money,” he reflects. “I would rather stay underinvested than chase the market down a risky path that inevitably leads to higher risk of losses.
“It’s hideously dangerous, making up a number and basing leverage on it, and a classic example of lack of discipline. I had one thing to say to those managers, ‘Goodbye!’”
Additional reporting from Andrew Hedlund and Rebecca Szkutak