One of Wall Street's Favorite Metrics Is Now Getting MockedBy , , and
Borrowers stretch limits of acceptable adjustments to Ebitda
Some debt offerings find ways to double earnings projections
In an anything-goes world for debt, there’s a new definition for Ebitda: Eventually Busted, Interesting Theory, Deeply Aspirational.
That’s the tongue-in-cheek assessment of a Moody’s analyst who’s been tracking earnings projections used by companies lately when asking investors for loans. Ebitda really means earnings before interest, taxes, depreciation and amortization, but borrowers have been stretching the limits of what’s acceptable when they tweak their accounting to boost the figure.
The adjustments -- known as “add-backs” in Wall Street lingo -- make companies look more creditworthy by increasing revenue and earnings forecasts. They’re legitimate when companies use them to factor out foreseeable or one-time events that might unfairly reduce the number. But in this frothy market, the size and vagueness of some add-backs seen in offering documents are raising eyebrows:
- Eating Recovery Center, which helps people with diet disorders, almost doubled Ebitda through add-backs for a debt sale last month to help finance CCMP Capital’s purchase of a controlling stake in the company. Almost half of the add-backs were calculated on the basis that the company will “capture the true earnings potential” of its expanded treatment centers.
- When whitening-agent firm Kronos Worldwide Inc. asked lenders for 400 million euros last month ($470 million), its earnings formula allowed wiggle room for half a dozen specific future actions, such as mergers, “and any operational changes.” Kronos didn’t say what that means.
- Avantor Inc.’s $7.5 billion financing, also last month, pitched an adjusted earnings figure amounting to a 91 percent hike. The industrial supplier claimed allowances such as shares awarded to employees as compensation, and operational benefits from a merger.
- GoDaddy Inc.’s offering back in February included 21 ways the web-hosting registration service could adjust Ebitda upward, including repeatable savings and synergies from anything it does, or expects to do, in “good faith” for a two-year period.
Derek Gluckman, senior covenant officer at Moody’s Investors Service who floated the cheeky definition for Ebitda, said frustrated investors have little choice but to buy because of the overheated market. “We are seeing the prolonged effects of the persistent supply-demand imbalance for loans, which favors the borrowers enormously,” Gluckman said.
Representative for Dallas-based Kronos and Denver-based Eating Recovery declined to comment, and officials at Avantor in Center Valley, Pennsylvania, didn’t respond to messages. Dan Race, a spokesman for GoDaddy, said the Scottsdale, Arizona-based company hasn’t disclosed its adjusted Ebitda since the fourth quarter of 2016.
The companies are all junk-rated, but none carries a grade that indicates risk of an imminent default -- and all of them ultimately found willing lenders.
“Investors are starved for loans and willing to accept terms they wouldn’t in another market,” said Andrew Curtis, head of the investment team for Z Capital Credit Partners.
Traditional add-backs let borrowers include future savings from cost-cutting or increases in revenue in their Ebitda. There’s nothing illegal or underhanded about the practice, and the offerings clearly lay out exceptions to potential creditors.
But in a market that’s already in danger of boiling over, aggressive attempts to make companies appear more creditworthy could be masking the true amount of leverage in the system -- and the pain for investors if the loans go sour. On top of that, the Trump administration is seeking to dial back regulations aimed at curtailing leverage, and a move is afoot in Congress to review and perhaps kill the current guidance from government agencies.
Add-backs without caps or restrictions for synergies and cost savings spread to 44 percent of new loan deals in the third quarter, from 27.1 percent in the first, according to research firm Covenant Review. In 2017, and each of the two preceding years, 91 percent to 94 percent of North American bonds had at least one Ebitda add-back considered aggressive by Moody’s.
“The problem is that the good faith standard doesn’t have a lot of teeth but it’s very difficult for anyone to challenge the company on it,” said Ian Walker, an analyst at Covenant Review. He’s also skeptical about promised improvements in performance from mergers. “Even if a borrower doesn’t realize synergies, they don’t have to deduct their unrealized synergies later,” Walker said.
More aggressive add-backs are one part of a trend toward weakening protections. The quality of covenants, or protections afforded to lenders, in junk bonds is hovering above a record low, according to Moody’s. Leverage levels are also near historical highs at 5.3 times in September, S&P Global Ratings said this week.
“Their language has become more broad, more wishful and less constrained,” said Jenny Warshafsky, of Xtract Research, which analyzes debt deals. “Some are becoming almost like blank checks, where any action you might take in the future which could potentially lead to cost savings can be used to manufacture Ebitda.”
While people are finding “new and creative ways to apply the same concept of either adding something that doesn’t yet exist, or not deducting something that is negative,” those examples are more on the margin and not near a level seen pre-financial crisis in 2007, said Steve Vaccaro, co-chief executive officer at CIFC Asset Management, with more than $15 billion under management.
Avantor’s 91 percent boost to achieve $1.037 billion of Ebitda outlined in deal documents reviewed by Bloomberg included $276 million in adjustments to its earnings and the earnings of VWR Corp., the company it bought, and $219 million of benefits from the merger. While some of those merger savings will be realized, Moody’s said achieving all of them is “unlikely.”
Investors aren’t always afraid to rebel. Avantor had to sweeten its terms after lenders questioned its earnings forecasts. Regulators have also clamped down. Last year, Federal Reserve bank supervisors cautioned Goldman Sachs Group Inc. over accounting adjustments in a debt deal it arranged to fund the $4 billion buyout of Ultimate Fighting Championship.
“There is a point where lenders go too far,” said Michael Barnes, co-chief investment officer at Tricadia Capital LLC with $2.4 billion under management. “You’re starting to see that line get crossed now.”
— With assistance by Sridhar Natarajan