Chart 1

The leverage of European speculative-grade debt issuers has risen progressively in recent years, as have the frequency and magnitude of their management teams' EBITDA adjustments on newly announced transactions. Investors are naturally skeptical of such overly favorable interpretations of prospective issuers' underlying earnings capacity and therefore their overall leverage.

When S&P Global Ratings analyzes new leveraged finance transactions, we typically meet with management, review EBITDA adjustments, and exclude the adjustments that we view as less plausible predictors of recurring cash flow from our adjusted forecasts.

In this article, we compare the aggregate debt-to-EBITDA statistics issuers presented to investors with the S&P Global Ratings-adjusted debt-to-EBITDA figures we use in our credit ratings, to highlight the different ways of evaluating leverage.

S&P Global Ratings-Adjusted Leverage Is Higher Than Issuer-Reported Leverage

In the nine months to September 2019, we rated €691 billion of European leveraged loans and bonds. For these new transactions, our analytical adjustments to debt and EBITDA raise the average opening leverage to a mean of 6.8x from a mean of 5.3x using the figures that issuers' management teams presented (see chart 1). In aggregate, S&P Global Ratings-adjusted leverage is roughly 1.5x higher than the figure that issuers' management routinely presented to investors in this period.

In analyzing a company's leverage, we prepare financial forecasts based on our own views of future revenues, costs, and cash flows. These adjustments fall into three main categories:

• Capitalization of lease adjustments and rents.
• EBITDA adjustments for financial ratio purposes.
• Shareholder loans.

Our analytical adjustments for leases account for much of the difference between our measure of debt to EBITDA and that issuers present to the market.

Even before the introduction of International Financial Reporting Standard (IFRS) 16 "Lease Accounting", S&P Ratings consistently capitalized operating leases and added them back to our calculation of debt and EBITDA. While this approach affects some sectors more than others, it increased debt by an average of about 20% for the nine months to September 2019. However, the impact on our adjusted leverage figure is substantially lower than the increase in debt due to the corresponding adjustment we make to EBITDA for rent.

We expect to no longer need to make these lease adjustments for companies reporting under IFRS from 2020, as we will generally accept the new IFRS 16 accounting, which incorporates operating leases into the balance sheet.

In terms of shareholder loans, most of those raised in the nine months to September 2019 meet our criteria for non-common equity treatment, and therefore did not impact the leverage statistics. The seven cases that did not meet our criteria have a small impact on our calculation of average leverage in the nine months to September 2019.

For more details on our adjustment methodology, see "Corporate Methodology: Ratios and Adjustments," published April 1, 2019, on RatingsDirect.

Have European Speculative-Grade Debt Issuers Reached Peak Leverage?

The European Central Bank's (ECB's) guidance on leveraged transactions advises that highly leveraged transactions--meaning those with debt to EBITDA of more than 6x--should remain the exception rather than the rule:

"Syndicating transactions presenting high levels of leverage--defined as the ratio of total debt to EBITDA exceeding 6.0 times at deal inception--should remain exceptional (and a potential exception should be duly justified) and form part of the credit delegation and risk management escalation framework of the credit institution. For most industries, a leverage level in excess of 6.0 times total debt to EBITDA raises concerns."

The ECB's guidance does provide flexibility in the calculation of EBITDA, stating that "Any enhancements to EBITDA should be duly justified and reviewed by a function independent of the front office function."

Issuers typically offer two factors as mitigating their high leverage. The first is that interest coverage levels are much higher than in 2007 and 2008. This is certainly true, assisted, of course, by very low interest rates, which reduce the financing burden considerably. However, at some point, issuers will need to demonstrate their ability to repay the debt.

The second mitigant is the higher equity cushion from financial sponsors in post-2009 transactions compared to pre-2009 transactions. Typically, this cushion exceeds 40%, compared to just above 30% pre-2009. This is certainly a source of comfort for the senior debt providers. However, the skeptical observer might argue that this equity cushion replaces the subordinated debt in many pre-2009 structures. Although the cushion to absorb losses is not necessarily greater than the subordinated debt in pre-2009 structures, we think the lack of interest burden on this extra debt is positive.

A "True" Measure Of Leverage May Be Elusive

In reality, it is perhaps an impossible task to calculate true leverage as there are many different views as to what constitutes EBITDA, and even what constitutes debt. (For the definitions we use, see "Corporate Methodology: Ratios and Adjustments".)

This leads to divergent opinions as to what is a "true" measure of leverage. However, we believe our adjusted leverage figure is a useful benchmark, as it excludes the more extreme EBITDA adjustments and thereby provides a more standardized and comparable measure of a company's debt burden.

A Deeper Dive Into The Data

The starting point for our analysis was S&P LCD's monthly leverage statistics from bank books and issuer presentations going back many years (see chart 2). These data are widely used by investors to benchmark new leveraged finance transactions and determine the market trends for newly issued debt. The data are pro forma the debt transactions and therefore differ from the borrowers' reported financial accounts.

Chart 2

Although we have attempted to match S&P LCD's issuer population as closely as possible, there are differences between S&P Global Ratings-adjusted data and S&P LCD's data. Accordingly, direct comparisons should be avoided. For the nine months to September 2019, the S&P Global Ratings dataset consisted of 111 companies, while the LCD dataset consisted of up to 150 companies. However, we believe that all of the S&P Global Ratings companies for which we have adjusted EBITDA are part of the LCD dataset.

For issuers that raised new debt in the nine months to September 2019, S&P Global Ratings' view of average leverage clearly exceeds the issuer-reported figures. EBITDA in each case is for the current financial year--which for most companies in the dataset ends in December 2019--and the figure is an unweighted average.

Related Criteria

• Corporate Methodology: Ratios and Adjustments, April 1, 2019

Related Research

• Topical: First-lien leverage rises above 5x, LCDComps, May 30, 2019