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U.S. investors in leveraged loans are increasingly worried that companies’ use of projected earnings figures in leveraged buyouts (LBOs) could blow up if the market turns south, derailing companies from meeting their revenue expectations and leaving them hung with billions in debt.

Borrowers, many of which binged on leveraged loans to finance hefty buyouts, have in recent years ramped up their usage of add-backs, or projected cost savings such as staff cuts, to lower debt-to-earnings before interest tax, depreciation and amortization (debt-to-Ebitda) numbers in a bid to make leverage calculations more palatable to both investors and regulators.

Ebitda adjustments reflect assumptions about companies’ future earnings potential. These adjustments and projections, however, may not be achievable and could be masking the true amount of leverage and debt that private equity firms are using, as well as the risk inherent in transactions.

“Unjustified add-backs will be the biggest issue in this cycle,” said Tim Gramatovich, chief investment officer at Gateway Credit Partners, a division of B. Riley Financial. “We went from Ebitda, to adjusted Ebitda, to further adjusted Ebitda to pro-forma (Ebitda)… It’s almost comical.”

Such flexible terminology is yet another symptom of the market’s restricted supply. So long as investor demand is superior, these looser borrowing terms will persist, said Christina Padgett, a senior vice president and head of the leveraged finance practice at Moody’s Investors Service.

“There has been a mismatch in bargaining power. Borrowers are able to exert greater influence and will try to wring everything they can out of the credit document,” she said.

Market participants question how such ambitious cost saving measures can be accounted for before an acquisition takes place. Some also fear whether add-backs could become a regular feature across both the broadly-syndicated market and the middle market, which hasn’t been immune to such adjustments.


Blackstone’s approximately US$20-billion LBO of Thomson Reuters’ Financial and Risk business, Refinitiv, lapped up insatiable buyside demand in September 2018, enabling it to include Ebitda add-backs based on projected cost savings. LPC is a division of Refinitiv.

The purchase boosted interest for similar LBOs including Envision Healthcare’s US$9.9-billion buyout by KKR. The physician services provider, which raised US$5.45-billion in term loan debt to fund the buyout last September, had leverage of 7.2 times, according to Moody’s, but it was marketed at less than 7.0 times due to Ebitda adjustments, LPC reported at the time.

The success of these highly-levered, multibillion-dollar transactions ushered in increasingly aggressive LBOs on the back of a stable economy and a relatively low pricing environment, two senior leveraged finance bankers said.

Johnson Controls’ Power Solutions in March raised US$6.45-billion-equivalent in loans to back its acquisition by Brookfield Business Partners. Along the way, it tightened a most favored nations clause on Ebitda add-backs and included language allowing for additional debt increases and restricted payments.

Sinclair Broadcast Group is in the market to raise US$3.3-billion in seven-year term loan debt and a further US$300-million through a five-year revolving credit facility to partially fund the acquisition of Walt Disney’s regional sports networks announced this month.

Sinclair, which said it had a financing commitment in place from JP Morgan, Deutsche Bank, the Royal Bank of Canada and Bank of America Merrill Lynch, is expected to increase pro-forma leverage to 5.3 times earnings from 3.1 times as of the end of 2018, according to S&P Global Ratings.

Sinclair, rated BB- by S&P Global, risks being downgraded if leverage swells above 5.5 times, the ratings agency said in a report this week, and sources suggest the broadcaster will find the necessary add-backs needed to trim its debt-to-Ebitda.

Since 2013, US regulators have been wary of leverage ratios above 6.0 times Ebitda, but this is a guideline, and adjusted leverage levels are often higher.

“We are cognizant that Ebitda is becoming a marketing number (in a buyout) and that doesn’t always reflect the truth,” said Jeremy Burton, a portfolio manager at PineBridge Investments.

To be fair, not everyone is skeptical as savvy investors will have protected themselves. Sponsor-backed LBOs, for example, typically provide investors with reports that determine the “quality of earnings,” thus disclosing relevant information needed to make investment decisions, said Steve Rutkovsky, a partner at Ropes & Gray’s finance practice.

“The market won’t just take hits on add-backs hook, line and sinker,” he said. “Lenders are provided with reconciliation of Ebitda and adjustments. The information is there if needed.”

Credit ratings agencies also provide impartial third-party analysis. Padgett said analysts evaluate comparable companies with similar add-back strategies to determine the viability of an LBO’s proposed cost savings.

“That (information) isn’t necessarily what the company is asking us to use,” she said about independent analysis of add-backs, adding that ratings agencies and companies would sometimes “agree to disagree” on the analysis.

Large-scale LBOs such as Refinitiv and Envision saw private equity place a significant amount of equity into these transactions, and Rutkovsky said sponsors wouldn’t go forward unless they were “confident” their add-backs would be realized.

“Credit agreements are as aggressive as ever right now, but these companies have way too much to lose if investors are not convinced by their add-backs,” a managing director at a US investment bank said.

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