In an anything-goes world for debt, there's a newdefinition for Ebitda: Eventually Busted, Interesting Theory,Deeply Aspirational.

That's the tongue-in-cheek assessment of a Moody's analyst who'sbeen tracking earnings projections used by companies lately whenasking investors for loans. Ebitda really means earningsbefore interest, taxes, depreciation and amortization, butborrowers have been stretching the limits of what's acceptable whenthey tweak their accounting to boost the figure.

The adjustments—known as “add-backs” in Wall Street lingo—makecompanies look more creditworthy by increasing revenue and earningsforecasts. They're legitimate when companies use them to factor outforeseeable or one-time events that might unfairly reduce thenumber. But in this frothy market, the size and vagueness of someadd-backs seen in offering documents are raising eyebrows:

• Eating Recovery Center, which helps people with diet disorders,almost doubled Ebitda through add-backs for a debt sale lastmonth to help finance CCMP Capital's purchase of a controllingstake in the company. Almost half of the add-backs were calculatedon the basis that the company will “capture the true earningspotential” of its expanded treatment centers.
• When whitening-agent firm Kronos Worldwide Inc. asked lendersfor 400 million euros last month ($470 million), its earningsformula allowed wiggle room for half a dozen specific futureactions, such as mergers, “and any operational changes.” Kronosdidn't say what that means.
• Avantor Inc.'s $7.5 billion financing, also last month, pitchedan adjusted earnings figure amounting to a 91% hike. The industrialsupplier claimed allowances such as shares awarded to employees ascompensation, and operational benefits from a merger.
• GoDaddy Inc.'s offering back in February included 21 ways theweb-hosting registration service could adjust Ebitda upward,including repeatable savings and synergies from anything it does,or expects to do, in “good faith” for a two-year period.

Derek Gluckman, senior covenant officer at Moody's InvestorsService, who floated the cheeky definition for Ebitda, saidfrustrated investors have little choice but to buy because of theoverheated market.

“We are seeing the prolonged effects of the persistentsupply-demand imbalance for loans, which favors the borrowersenormously,” Gluckman said.

Representative for Dallas-based Kronos and Denver-based EatingRecovery declined to comment, and officials at Avantorin Center Valley, Pennsylvania, didn't respond to messages.Dan Race, a spokesman for GoDaddy, said the Scottsdale,Arizona-based company hasn't disclosed its adjusted Ebitda sincethe fourth quarter of 2016.

The companies are all junk-rated, but none carries a grade thatindicates risk of an imminent default—and all of them ultimatelyfound willing lenders.

“Investors are starved for loans and willing to accept termsthey wouldn't in another market,” said Andrew Curtis, head of theinvestment team for Z Capital Credit Partners.

Legitimate Practice

Traditional add-backs let borrowers include future savings fromcost-cutting or increases in revenue in their Ebitda. There'snothing illegal or underhanded about the practice, and theofferings clearly lay out exceptions to potential creditors.

But in a market that's already in danger of boiling over,aggressive attempts to make companies appear more creditworthycould be masking the true amount of leverage in the system—and thepain for investors if the loans go sour. On top of that, the Trumpadministration is seeking to dial back regulations aimed atcurtailing leverage, and a move is afoot in Congress to review andperhaps kill the current guidance from government agencies.

Add-backs without caps or restrictions for synergies and costsavings spread to 44% of new loan deals in the third quarter, from27.1% in the first, according to research firm Covenant Review. In2017, and each of the two preceding years, 91% to 94% of NorthAmerican bonds had at least one Ebitda add-back consideredaggressive by Moody's.

“The problem is that the good-faith standard doesn't have a lotof teeth but it's very difficult for anyone to challenge thecompany on it,” said Ian Walker, an analyst at Covenant Review.

He's also skeptical about promised improvements in performancefrom mergers. “Even if a borrower doesn't realize synergies, theydon't have to deduct their unrealized synergies later,” Walkersaid.

More aggressive add-backs are one part of a trend towardweakening protections. The quality of covenants, or protectionsafforded to lenders, in junk bonds is hovering above a record low,according to Moody's. Leverage levels are also near historicalhighs at 5.3 times in September, S&P Global Ratings saidthis week.

“Their language has become more broad, more wishful and lessconstrained,” said Jenny Warshafsky, of Xtract Research, whichanalyzes debt deals. “Some are becoming almost like blank checks,where any action you might take in the future which couldpotentially lead to cost savings can be used to manufactureEbitda.”

While people are finding “new and creative ways to apply thesame concept of either adding something that doesn't yet exist, ornot deducting something that is negative,” those examples are moreon the margin and not near a level seen pre-financial crisis in2007, said Steve Vaccaro, co-CEO at CIFC Asset Management, withmore than $15 billion under management.

Avantor's 91% boost to achieve $1.037 billion of Ebitda outlinedin deal documents reviewed by Bloomberg included $276 million inadjustments to its earnings and the earnings of VWR Corp., thecompany it bought, and $219 million of benefits from the merger.While some of those merger savings will be realized, Moody's saidachieving all of them is “unlikely.”

Investors aren't always afraid to rebel. Avantor had to sweetenits terms after lenders questioned its earnings forecasts.Regulators have also clamped down. Last year, Federal Reserve banksupervisors cautioned Goldman Sachs over accounting adjustments ina debt deal it arranged to fund the $4 billion buyout of UltimateFighting Championship.

“There is a point where lenders go too far,” said MichaelBarnes, co-chief investment officer at Tricadia Capital with $2.4billion under management. “You're starting to see that line getcrossed now.”

From: Bloomberg News

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