Adjusted EBITDA Hides Higher Leverage on Buyout Loans

LONDON (LPC) – Investors in European leveraged loans are increasingly worried that private equity firms are making too aggressive adjustments to portfolio company profits to support higher leverage.

EBITDA is a benchmark cash flow figure used by bankers to calculate a company’s leverage and business transactions with investors, and the adjustments reflect assumptions about the companies’ potential for future earnings.

Investors are concerned that these adjustments and projections may not be achievable and mask the true amount of leverage and debt that private equity firms are using, as well as the risk involved in transactions.

“At the start of the financial crisis, you saw the same things happen. Private equity firms have always pushed the limits of the Ebitda they will get from lenders, ”said one fund manager.

Higher EBITDA figures allow companies to borrow more and show lower overall debt levels. Without adjustments, leverage ratios would be much higher, which could make transactions difficult to sell to investors and alert regulators.

The European Central Bank has followed US regulators in capping leverage ratios at six times EBITDA, but this is a guideline, and even adjusted leverage levels are often higher.

A recent buyout loan equivalent to € 880 million in euros and pounds sterling backing pharmaceutical maker Zentiva ROSCD.BX the acquisition by Advent had a leverage of 7.1 times based on 2017 adjusted EBITDA.

Private equity firms cite lower average EBITDA levels as a sign of a healthy market and regularly use them to differentiate between current market conditions and the market peak before the 2008 financial crisis.

But as resistance to aggressive loan documents grows, many investors are critical of the scale of the current EBITDA adjustments and demanding changes.

The € 760million B-term loan from private Finnish healthcare firm Mehilainen sparked broad forecasts this week and required a series of changes to clear the market, including reducing adjustments to the definition of EBITDA. The deal funded the acquisition of the company by CVC.

Adjustments related to expected synergies from mergers and acquisitions stand the best chance of being made, rating agency Moody’s said in a June report.

“We worked with a company where M&A adjustments were very high, but the market accepted them because they have a history of delivery,” said a co-head of leveraged finance.

One-off “add-ons”, where companies claim one-time cost savings, are a bigger problem. Only 45% of those adjustments were made on average and nearly 20% of issuers did not make any of their projected adjustments, Moody’s said.

These unusual adjustments are on the rise, causing issuers’ EBITDA adjustments to increase to an average of 14% last year from 9.6% in 2016, according to the rating agency.

“We are getting more and more questions about the EBITDA adjustments. As an investor, it is not always easy to pass judgment given the low level of detail often available, ”said a London-based analyst.

IN THE MIDDLE MARKET

According to S&P, about 77% of the global leveraged loan market is covenant-lite. More and more middle market loans have covenants, but aggressive definitions of EBITDA compromise the limited protection of lenders.

“What is the value of the covenants with this level of EBITDA adjustment?” With that leeway, there has to be such a deterioration of the business before it bites, ”said a lawyer.

The direct lending market is not immune to EBITDA adjustments either. Core Equity Holdings recently acquired a stake in UK company Portman Dental Care with approximately £ 100million debt financing provided by Alcentra, based on an EBITDA of £ 20million, which had been adjusted from £ 9million.

Portman has grown rapidly in recent years, nearly tripling the number of practices since 2014, but many lenders balked at the adjustment, which more than doubled EBITDA.

“It’s a huge multiple,” said a second fund manager.

Discipline on documentation is stronger in the private debt market compared to larger transactions due to the riskier nature of the businesses.

In the United States, where the private debt market is deeper, 35% of middle market loans have undergone EBITDA adjustments, according to Covenant Review. Synergy-related adjustments are capped at around 10% -15% on the middle market, based on projections for the next 12 or even 18 months.

But the list of one-offs, including uncapped one-time payments, also leaves lenders exposed to limited payments and new debt issuance from sponsors, which can weaken the position of investors.

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