EBITDA is a controversial financial metric widely used in the private equity and leveraged credit space. One would think the calculation of EBITDA would be straightforward—it’s right there in the name: “Earnings Before Taxes Interest Depreciation and Amortization.” Yet when credit markets are hot, borrowers start to get creative with EBITDA calculation.
Why use EBITDA?
Theoretically, EBITDA allows an investor to compare two companies with similar businesses with different capital structures. A private equity buyer uses it because they are usually able to change the capital structure after taking control. It’s also potentially valuable to lenders, because it roughly measures a company’s interest payment capacity. Most BDCs will report EBITDA interest coverage and/or EBITDA leverage of their portfolio companies. The Office of the Comptroller of the Currency (OCC) uses EBITDA as a metric in its leveraged lending guidelines.
Earnings before the bad stuff
EBITDA is a non-GAAP metric, with some vocal critics. Public companies reporting EBITDA are required by the SEC to reconcile to net income. Some investors are highly critical of the use of EBITDA. Charlie Munger of Berkshire Hathaway reportedly once said “I think that, every time you see the word EBITDA, you should substitute the word ‘bullshit’ earnings.” His criticism is based on the fact that over the long run, depreciation is a real expense for most businesses, and companies need to make capital expenditures to stay in business. Therefore, EBITDA, without adjusting for actual capital expenditures, might overstate the cash generating ability of a business over the long run. Nonetheless, it remains a widely used proxy of a company’s interim ability to service debt.
Community adjusted EBITDA
EBITDA is already an “adjusted” metric, but when markets are hot, borrowers often make even more adjustments. Bloomberg and the Financial Times both recently reported on the increasing prevalence of EBITDA “add backs,” which allow borrowers to include future savings from cost cutting or increases in revenue in their EBITDA. Sometimes this may be justified by a unique business model, other times it appears disingenuous. According to Moody’s (cited by Bloomberg), 91% to 94% of North American bonds it reviewed between 2015 and 2017 had at least one aggressive EBITDA add back. One analyst called the new EBITDA “Eventually Busted, Interesting Theory, Deeply Aspirational.”
According to Bloomberg, “in a market that’s already in danger of boiling over, aggressive attempts to make companies appear more creditworthy could be masking the true amount of leverage in the system.” Deals with adjustments to EBITDA were at a "multi-decade high" in the first quarter of 2018, Financial Times notes. "The practice means that leverage in the corporate debt markets is probably higher than reported." The current head of the OCC has hinted that they will let leveraged lending guidelines slide going forward, so the general trend towards loose credit may continue until borrowers struggle to pay back loans.
Several well-known known borrowers have used aggressive EBITDA addbacks in credit agreements recently, including Blue Nile, Ultimate Fighting Championship (which did actually manage to get flagged by regulators), Groupon, and Restoration Hardware. But the most amusing is WeWork, which recently issued bonds using what it called “community adjusted EBITDA.” As FT Alphaville pointed out: WeWork is apparently telling bond investors that 97% of operating expenses are non-recurring. Maybe that is right, and maybe it’s wrong, but it’s certainly not something you see at market bottoms.
It’s a challenging environment for prudent lenders to maintain discipline. We’ll continue to monitor trends affecting the credit quality of underlying investments of programs we cover, including credit-focused interval funds and BDCs.