(Corrects language in first paragraph)
By David Brooke
NEW YORK, Jan 14 (LPC) - Middle market lenders are starting to feel the pinch of aggressive borrower-friendly features meant to reduce leverage as companies fail to hit revenue expectations and remain saddled with billions of dollars in debt.
Tools such as earnings before interest, tax, depreciation and amortization (Ebitda) add-backs have become increasingly prevalent in the last two years as sky-high valuations have pushed private equity borrowers into more creative forms of funding growth including bolt-on strategies.
An Ebitda add-back is a cost saving or synergy that is added to the profits of a business to show higher projected earnings. Such forecasts, however, may not be achievable and could be masking the true amount of leverage that private equity firms are using, as well as the ultimate risk of participating in a transaction.
“Ebitda add-backs are a reflection of sponsors paying increased purchase multiples and the overreliance on non-organic growth to obtain returns,” said one private credit fund manager.
With signs of a slowing US economy weighing on growth, middle market companies are having a harder than expected time relying on future cost savings to meet ambitious earnings targets, which could be even more problematic in the event of a downturn.
Deals arranged in 2015 showed misses of 29% in 2016 and 34% for 2017, according to an S&P Global report. Deals arranged in 2016 recorded an average Ebitda miss of 35% in both 2017 and 2018.
Popular Ebitda adjustments are either proceeds from planned cost-cuttings or potential boosts in revenues from synergies in integrating target companies. Art Penn, managing partner at asset manager PennantPark, calls the latter “a hope and a dream.”
“Some of the add-backs that are synergies are not as tangible and more of a hope that they will occur. They also won’t be immediate so it’s a lot harder for a skeptical underwriter to believe that story,” Penn said.
Timelines for a borrower to meet leverage targets are being pushed out beyond the historical average of 12-18 months to 18-24 months, market participants say. The average debt basket was 29% in the first half of 2019, up from 23% in 2018, according to a report from law firm Proskauer.
Middle market lenders are aware that earnings expectations could tank if the market turns south, leaving companies hung with billions in debt.
A recent Refintiv LPC survey showed that 38% of lenders believe a downturn is most likely in the first half of 2021 and 26% predict it will be at some point in 2020. The majority are now modelling projections through a recession and modifying their strategy accordingly.
“We’re looking at each transaction and sensitizing assets to how they perform in a downturn. We’re particularly selective around cyclical sectors and tightening the duration risk,” said Karen Davies, a managing director at Huntington National Bank.
If and when the downturn hits, direct lenders in the middle market might be more willing to work with sponsors to keep disputes out of the courtroom. Often, they can be the sole lender and private equity funds, that are sitting on large amounts of dry powder, can pour money into an ailing company.
A growing concern, however, is that private equity borrowers are placing that money into the senior debt last out piece of the financing, putting themselves ahead of second-lien lenders and unsecured claimants.
Although, failing to meet revenue expectations from add-backs may cause borrowers to trip maintenance covenants, a more significant concern is the incremental debt or dividends that can result from an inflated Ebitda.
“I lose even more sleep over the leakage permitted by the incurrence test than I do with respect to the financial covenant. If an investment is made or worse off, a dividend is taken pursuant to an incurrence test based on inflated Ebitda, that money is not coming back,” said Bill Brady, partner at law firm Paul Hastings. “You can’t unring that bell.” (Reporting by David Brooke. Editing by Michelle Sierra)