Story of the Year: How trustworthy is EBITDA?

EBITDA addbacks became an increasing cause for concern in 2019 as borrowers stretched the bounds of permissible adjustments.

Move over covenant-lite loans, there’s a new piece of financial “innovation” to worry about. 2019 has been all about the EBITDA addback, seen by some as “the most egregious example” of how investors will accept any demand from a borrower as merely the price of playing in the market, wrote Andy Thomson, editor of sister publication Private Debt Investor, back in June.

Addbacks are essentially a sum of money added back to the profits of a company, normally to account for savings from synergies that a sponsor expects to reap from an acquisition. Adding back gives a more realistic idea of how much a company is worth, supporters say. Some addbacks make sense. For example, if, post-acquisition, a company moves its headquarters to a cheaper city, there is a clear future cost saving that should be taken into account.

The problem is that using addbacks to inflate EBITDA effectively disguises the amount of leverage on a deal. Total leverage tends to be expressed as a multiple of EBITDA; when looking at an EBITDA figure, there’s no way of knowing how addbacks have contributed.

An example that PEI gave in its Numbers that lie feature in November: if a company has $30 million in EBITDA and this is adjusted up to $50 million, which is then levered 5x for a total debt amount of $250 million, the “real” debt-to-EBITDA ratio could actually be more than 8x.

In the past, addbacks were fairly well-controlled. You needed a cap on the amount that could be added back and a defined time limit within which the projected synergies had to be realised. Addbacks could only be used in the case of acquisitions.

These limits have been breached more and more in recent years. Data from Xtract Research show that in 33 percent of loans, projected synergy addbacks were uncapped, meaning there was no limit on the amount that could be added back.

“The nickname of EBITDA is Earnings Before I Trick the Dumb Accountants,” said Ludovic Phalippou, professor of financial economics at Oxford University’s Saïd Business School. “The number of adjustments you can do with EBITDA can reach the sky. I have no faith in any EBITDA number and a lot of transactions are quoted as what is enterprise value as a function of EBITDA, but EBITDA can be computed infinitely and not just one way.”

There are some eye-popping examples of addbacks in action. Mikael Huldt, head of alternative investments at Stockholm-based AFA Insurance, relayed an example of one borrower trying to get addbacks based on all Brexit-related costs. Sales would have been higher had it not been for Brexit, and the EBITDA figure should reflect this, they argued.

Up to now the excessive use of addbacks has been confined to larger, widely syndicated deals. The mid-market is beginning to feel pressure, however, as borrowers grow to expect more flexibility from lenders in other parts of the market. Next time a GP tells an investor that it doesn’t overpay for assets, that investor might want to ask them to prove it.