‘Fake Ebitda’ Makes Covenant Risk in Debt-Laden Companies
Last week, Bloomberg published a story called ‘Fake Ebitda’ Masks Risk in Debt-Laden Companies, noting how bad management is at forecasting EBITDA.
A report from S&P reveals that 97%of sub-IG companies that announced acquisitions in 2019 fell short of EBITDA forecasts in their first year of earnings.
According to Covenant Review data, by2019 add-backs (the bit of EBITDA estimated by management) accounted for about28% of total adjusted EBITDA figures used to market acquisition loans, up from17% in 2017.
Looking at this from a covenant angle(which I love to do), a much bigger risk emerges for lenders than just masked leverage. Most calculations in the contemporary covenant package use EBITDA to calculate capacity for the borrower to do just about everything from borrowing more debt to paying dividends, either through a leverage ratio or soft-caps.
Indeed, in deals with a portability clause, EBITDA is used as part of the calculation that determines whether a private equity sponsor can sell the company to a new owner without triggering a change of control offer.
Taking the data above in this context means that borrowers are using a figure that management is incredibly bad at predicting – that they overestimate in almost every case – to take actions (borrowing debt, paying dividends) that could prove detrimental to lenders.
That’s not all – as we cover in the Calculation Mechanics chapter of FLT’s Leveraged Finance Covenant Training –compounding this risk is the fact that terms allow management to cherry-pick the best EBITDA figure to get the most favourable outcome. It’s not just LTMEBITDA as of the date the debt is borrowed, or the dividend is paid, in some cases it’s the last two quarters multiplied by two (L2QA EBITDA) or even the last quarter multiplied by four.
It gets even more risky when you take into account the “super-grower”, a provision that will adjust the fixed amount of a basket up with the EBITDA grower, but won’t ever require it to be adjusted down if EBITDA declines, preserving the rosiest predictions of management.
What does this mean to lenders? Sub-IG borrowers, who are notoriously bad at forecasting EBITDA, can nonetheless calculate covenant capacity based on these rosy predictions. This is about more than just financial reporting – once debt is borrowed, or dividends paid, even if the forecast proves to be optimistic (which is almost certain to be), the genie is out of the bottle and there’s no getting it back in.
And given that 97% of sub-IG borrowers are falling short of predictions, it looks like lenders are going to need more than three wishes.
By Sabrina Fox - Founder