A recent analysis of deals originated from 2015–2018 by S&P Global Ratings has found that many issuers’ earnings projections, especially ones factoring in the use of add-backs, have been falling short, leading to higher levels of leverage than initially shown on a pro forma basis when the deals were being marketed.

"We found that both EBITDA growth and deleveraging efforts fell materially short of issuer projections for the two years that we tracked companies' performance after transaction origination," S&P analysts Olen Honeyman and Hanna Zhang wrote in the Sept. 19 report. 

For deals originated in 2016, actual net leverage ended up being close to 2.0x higher than the marketed levels on a median basis in 2017 before rising to 2.5x higher in 2018. 

Much of the disparity has been driven by earnings projections not living up to initial forecasts. On average, the companies issuing in 2016 missed their earnings forecasts in 2017 by 35%, with 32% of those companies missing by more than 50% in both 2017 and 2018. On the other hand, no companies exceeded their projections in 2017 and only 6% did so in 2018. 

This all comes as many investors in the leveraged finance community call into question the validity of many of the add-backs being touted in the pro forma EBITDA numbers when deals are marketed.

The magnitude of add-backs continues to be significant, with synergies and cost savings now making up about a third of their expected impact, according to the analysis. S&P Global Ratings used a sample of 148 M&A and 110 LBO transactions originated since 2015 for the report.

From 2015–2018, cost savings/synergies made up 31% of add-backs, followed by restructuring costs at 17%, management fees/executive compensation at 16%, 13% in transaction costs, and 13% classified as non-recurring operating savings, followed by a 10% chunk that did not fit into any of those other categories. 

The sectors with the most prevalent use of add-backs were media/entertainment/leisure, technology, and healthcare. 

Ultimately, the S&P analysts found that the increasing use of add-backs can add incremental "event risks" to a deal, since a number of covenants that rely on EBITDA may then give private equity firms more flexibility when it comes to restricted payments.

"When the credit cycle turns, it will be interesting to observe the default and recovery performance of entities with substantial EBITDA add-backs as the legitimacy of several add-backs comes into question and suggests that the implied pro forma leverage for such deals is a misleading indicator of credit risk," Honeyman and Zhang concluded.

The full report titled "When the Cycle Turns: The Continued Attack of the EBITDA Add-Back" (client-only access) can be found on RatingsDirect.

LCD is an offering of S&P Global Market Intelligence. S&P Global Ratings is a separately managed division of S&P Global.

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