The financial crisis put a much greater emphasis on robust regulation of the banking sector. Leveraged lending practices, in particular, were put under a microscope. Human nature is such that, when confronted with strict rules, we are invariably prompted to devise creative ways to circumvent them. EBITDA add-backs have become an elegant tool to sidestep new and more onerous leverage level restrictions imposed by regulators and indeed financial institutions. In this article, we will begin by providing a high-level overview of the regulatory landscape applicable to leveraged lending. We will subsequently describe EBITDA-add backs, their utility and potential risks associated to them in the context of a financing transaction.
Leveraged Lending – Regulatory Landscape
Following the implosion of Lehman Brothers in 2008, the regulatory landscape in the global banking sector irreversibly changed forever. The global economy suffered an unprecedented blow. We came dangerously close to reverting to a barter economy. What followed was chaos, introspection and tons of regulation. It was patently urgent to ensure that certain underwriting mistakes of the past would not be replicated as they posed a systemic risk for the global financial system. It would be difficult to argue that the relaxed leveraged lending practices of financial institutions did not have a big hand in the financial meltdown. Unsurprisingly, these practices, which were already being scrutinized and monitored by regulators, became an increasing source of concern. Nowhere was it more crucial to tackle these loose practices than in the US. On March 22, 2013, the Federal Reserve Board, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency (collectively, the "US Agencies") issued the Interagency Guidance on Leveraged Lending ("US Guidance").
In a nutshell, the US Guidance outlines high-level principles to ensure that financial institutions conduct leveraged lending activities in a safe and sound manner and with creditworthy borrowers. The expectation of the US Agencies is that financial institutions take all necessary measures to originate loans with a sensible business premise, a sustainable capital structure and a capacity by the borrower to repay the loan or to de-lever it to a sustainable level over a reasonable period of time, the whole to avoid generating systemic risks for the financial system.
The US Guidance sets out general policy expectations that should be reflected in the credit policies and in the leveraged lending procedures of financial institutions. It also provides for a more granular list of minimum underwriting standards. The standard established by the US Agencies in respect of acceptable leverage levels of a company attracted much attention from the press and financial institutions alike. A leverage level after planned asset sales (i.e. the amount of debt that must be serviced from operating cash flow) in excess of 6x total debt to earnings before the deduction of interest, taxes, depreciation and amortization ("EBITDA") is considered by the US Agencies to raise a concern for most industries.
As a connected point, any adjustment (e.g. add-back) to a definition of EBITDA that is not supported by reasonable third party diligence as to appropriateness and scope would equally raise concern and attract criticism from the US Agencies.
While it is well documented that the Canadian banking regulatory landscape is generally quite robust and constraining, there is currently no written guidance or rules in place in Canada equivalent to the US Guidance. Nonetheless, Canadian financial institutions must adhere to conservative internal underwriting guidelines. We note, for example, that it is generally accepted in the Canadian market that a leverage level in excess of 3x senior debt to EBITDA raises red flags.
At first glance, one would think that these rules appear to be very sensible and are definitely a step in the right direction. As discussed in greater detail below, adjustments to EBITDA, albeit perfectly legitimate in some cases, can completely distort the credit profile of a company in other instances. With this in mind, financial institutions should asses the inclusion of EBITDA add-backs with a degree of caution and seek to obtain all necessary backup to corroborate the ask with supporting documentation explaining the underlying rationale in reasonable detail.
EBITDA is a non-GAAP calculation that sources information from a company’s income statement. It provides a better gauge of the operational strength of a company. Historically, lenders have focused on EBITDA as a means to determine the cash flow that a company has available to service its debt. The ratio of debt to EBITDA (i.e. leverage ratio) is, along with the fixed charge coverage ratio, one of the most common cash flow ratios. As such, EBITDA is one of the main components used in the financial covenants found in loan documentation.
An add-back is basically an expense that is added back to EBITDA with a view to improving the perceived profits of a company. The definition of EBITDA and the nature and scope of any add-backs to EBITDA in the loan documentation are typically heavily negotiated between borrowers, sponsors and lenders, particularly in the context of acquisition and leveraged loan transactions. Borrowers (especially sponsor backed) are quite keen to negotiate the inclusion of as many EBITDA add-backs as possible. There is a basic theory behind this. By increasing EBITDA, add-backs can improve cash flow ratios and afford more flexibility for a company to incur incremental debt. It also allows a company to take or omit to take certain actions that could adversely impact its credit profile without otherwise triggering a breach of its contractual undertakings under the loan documentation.
Adjustments to EBITDA could in fact have unintended knock-on effects on numerous areas of the loan documentation, including, without limitation:
- calculation of the leverage and the fixed charge coverage ratios;
- permitted baskets and carve-outs;
- excess cash flow mechanics;
- mandatory prepayments;
- applicable margin/pricing ratchets;
- availability of incremental loans;
- permitted acquisitions; and
- payment of dividends and/or junior debt.
Again, this is why lenders must be mindful of the associated risks of EBITDA add-backs when negotiating the underlying loan documentation.
Add-backs for actual transaction, restructuring and integration costs and expenses as well as extraordinary, unusual and non-recurring costs and expenses are relatively uncontroversial and usually acceptable to most lenders (pending reasonable support). However, add-backs for projected and unrealized cost savings or synergies (albeit reasonably supported) will be more challenging to negotiate. Careful consideration should be given by lenders to the period of time within which these cost savings will be realized. Even if acceptable conceptually, it would be prudent to ensure that these more opaque add-backs are the subject of a cap (anywhere between 5% to 20%) expressed as a percentage of unadjusted EBITDA.
The lending market is particularly competitive at the moment. Companies, especially those having an attractive credit profile, have disproportionate negotiating power. They will not shy away from using their makeup kit on EBITDA, especially if that means better pricing and more flexible terms for them. Aggressive lenders wanting to increase market share or desperately seeking to participate on a marquee transaction will need to strike a balance between their impulse to get the deal through and taking all means necessary to ensure that the transaction is underwritten in a safe and sound manner. Even if that means holding your ground against a sought-after borrower and performing additional diligence on the proposed EBITDA add-backs. As put so eloquently by Dale Carnegie: “The successful man will profit from his mistakes and try again in a different way”. After all, 2008 was not that long ago.