October 14, 2019 / 11:20 AM / a month ago

Adjusted Ebitda causes woe for lenders

LONDON, Oct 14 (LPC) - Lenders are concerned that adjustments to earnings on buyout deals are becoming too aggressive as borrowers get more creative in masking larger debt piles behind lower leveraged levels.

Adjusting Ebitda is a long term practice for borrowers tapping leveraged loans and high-yield bonds. While the practice is far more aggressive in the US, European borrowers are pushing the boundaries of acceptable adjustments, causing concern they are taking on unsustainable debt levels.

Borrowers are increasingly overestimating benefits from acquisitions by making assumptions of cost savings such as staff cuts and lower debt-to-Ebitda numbers in a bid to make leverage calculations more acceptable to investors and regulators.

Investors accept around 15%-20% of adjustments but in some cases, adjustments are inflating earnings to over 50%, bankers said.

Deals including the US$13.5bn financing backing the buyout of Refinitiv by a Blackstone-led consortium caused major concern among investors regarding the validity of add-backs and ability for the company to meet earnings targets, investors said.

LPC is owned by Refinitiv.

“The reason for adjusting Ebitda is so the Ebtida you’re leveraging off is a true reflection of the company to make money, in a lot of cases the adjustments are justifiable,” a capital markets head said.

“The risk is that people use adjustments to deflate marketing leverage, using the adjustments to hide how highly leveraged companies are and those companies will have an unsustainable debt load.”

MISSING TARGETS

Borrowers are systematically missing projections on their Ebitda, according to a report by S&P Global Ratings, which has reviewed US-originated merger and acquisition and leveraged buyout transactions over the past few years.

None of the sample companies achieved or exceeded their original Ebitda target by the end of first year, said the September S&P report, which is based on transactions from 2016. Only 6% of them met the target in the second year.

“The results do surprise me. It’s a very low hit rate. It basically says all the adjustments are fake,” a leveraged finance banker said.

The understated debt-to-Ebitda ratio masks the real scale of leverage, leading to an increased risk of default, especially in the economic downturn.

“We have consistently pointed to earnings adjustments as a major risk factor in the loan market,” UBS said in a report published on October 1.

UBS estimated that average total leverage for new deals was at 5.4 times based on adjusted earnings, compared with 6.7 times excluding add-backs. That exceeds the six times leveraged ratio that has been set by European and US regulators.

LIMITED CONSEQUENCE

Bain Capital’s buyout of chemicals firm Diversey is one example highlighting how bullish companies can be on earnings projections.

The 2017 deal, which compromised €1.8bn-equivalent loans and a €450m bond, included heavy adjustments with a “further adjusted Ebitda” figure, boosting the company’s earnings by almost 63%. And that put the firm’s leverage at 5.8 times, instead of pre-adjustment figures of 9.5 times.

The secondary prices of its euro loan tranche traded down sharply to hit below 90% of face value in June after it missed its 2018 earnings target. It reported US$321m Ebitda, well below US$360m-$380m guidance because of higher costs, foreign exchange and raw material inflation.

“When companies outline earnings add-back, they never tell you how much it is going to cost them to generate that,” an investor said. “And they miss the target, they get downgraded. But they don’t care about it because they already raised the money.”

There is no immediate consequence for missing targets and an ample demand for paper allows borrowers to get away with aggressive assumptions, especially for a solid credit.

“If the deals fly and is heavily oversubscribed, they will not get terms changed. If the deal needs lenders, clearly they will win some concessions,” the leveraged finance banker said.

“A good credit will always get away with this (bullish earnings add-back), a cyclical credit with limited appetite will not.”

The market dynamic is unlikely to change anytime soon.

“Investors are aware of what they are signing up to. I am sceptical if anything is going to change,” a lawyer said. (Editing by Christopher Mangham)

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