Adjusted Ebitda masks higher leverage on buyout loans

Zentiva SA

06/07/2018 17:23

By Max Bower and David Brooke
    LONDON, July 6 (LPC) - Investors in European leveraged loans
are increasingly concerned that private equity firms are making
overly-aggressive adjustments to portfolio companies’ earnings
to support higher debt loads.
    Ebitda is a benchmark cashflow figure used by bankers to
calculate a company’s leverage and market deals to investors,
and adjustments reflect assumptions about companies’future
earnings potential.
    Investors are worried that these adjustments and projections
may not be achievable and are masking the true amount of
leverage and debt that private equity firms are using, as well
as the risk inherent in transactions.
    “Going into the financial crisis you saw the same things
happening. Private equity firms have always pushed the
boundaries on what Ebitda they will get lenders to buy into,“ a
fund manager said.
    Higher Ebitda figures allow companies to borrow more and
make overall leverage levels appear lower. Without adjustments,
leverage ratios would be far higher, which could make deals
difficult to sell to investors and raise red flags with
regulators.
    The European Central Bank 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 €880m equivalent euro and sterling buyout loan
backing pharmaceuticals manufacturer Zentiva's  ROSCD.BX 
acquisition by Advent had leverage of 7.1 times based on
adjusted 2017 Ebitda.  
    Private equity firms cite lower average Ebitda levels as the
sign of a healthy market and routinely use them to differentiate
between current market conditions and the peak of the market
before 2008’s financial crisis.
    But as resistance to aggressive loan documents grows, many
investors are criticising the scale of current Ebitda
adjustments and demanding changes.
    Finnish private healthcare company Mehilainen’s €760m Term
Loan B priced wide of guidance this week and required a raft of
changes to clear the market, including reducing the adjustments
made in the Ebitda definition. The deal funded CVC's acquisition
of the company. 
    Adjustments linked to the synergies expected from mergers
and acquisitions have the best chance of being achieved, ratings
agency Moody’s said in a June report.
    “We’ve worked with one company where the M&A-related
adjustments have been very high but the market accepted them as
they have a track record of delivering,” a co-head of leveraged
finance said.
    One-off “add-backs”, where companies claim a non-recurring
cost saving, are a bigger problem. Only 45% of these adjustments
were achieved on average and nearly 20% of issuers achieved none
of their projected adjustments, Moody’s said.
    These unusual adjustments are rising, driving the increase
in issuer Ebitda adjustments to an average of 14% last year from
9.6% in 2016, according to the ratings agency.
    “We are getting more questions about Ebitda adjustments. As
an investor it is not always easy to make a judgement given the
poor level of detail often available,” a London-based analyst
said.
    
    INTO MIDDLE MARKET
    Around 77% of the global leveraged loan market is
covenant-lite, according to S&P. More middle-market loans have
covenants, but aggressive Ebitda definitions are undermining
limited protection for lenders.
    “What is the value of covenants with this level of Ebitda
adjustment? With this headroom there has to be such a
deterioration in the business before it bites,” a lawyer said.
    The direct lending market is also not immune to Ebitda
adjustments. Core Equity Holdings recently acquired a stake in
UK-based Portman Dental Care with around £100m in debt financing
provided by Alcentra, based on an Ebitda figure of £20m, which
had been adjusted up from £9m.
    Portman has expanded rapidly in the last few years, almost
tripling the number of practices since 2014, but many lenders
balked at the adjustment, which more than doubled Ebitda.
    “It’s a whopping multiple,” a second fund manager said.
    Discipline on documentation is stronger in the private debt
market compared with larger deals due to the riskier nature of
the companies.
    In the US, where the private debt market is deeper, 35% of
middle-market loans had Ebitda adjustments, according to
Covenant Review. Adjustments linked to synergies are capped at
around 10%-15% in the middle market, based on projections for
the next 12 or even 18 months.
    But the list of exceptional items, including uncapped
non-recurring payments, also leave lenders exposed to restricted
payments and further debt issuance by sponsors, which can weaken
investors’ position.
    

 (Editing by Tessa Walsh)
 ((tessa.walsh@thomsonreuters.com; +44 207 542 4048; Reuters
Messaging: tessa.walsh.thomsonreuters.com@reuters.net))