S&P Global Ratings' fifth annual analysis of EBITDA addbacks further substantiates that most U.S. speculative-grade corporate issuers cannot come close to achieving the earnings, debt, and leverage projections presented in their marketing materials at deal inception. Our study is a reminder that, in general, EBITDA adjustments do not provide an accurate picture of future earnings.

Our updated analysis consists of two main components:

• First, we added a new cohort of large M&A and LBO transactions that originated in 2019 (the fifth cohort of transactions in our dataset) to assess the validity of the addbacks in company forecasts. Consistent with our prior studies, we compared issuers' projected adjusted EBITDA at deal inception with actual reported EBITDA for the two calendar years following the year of origination. This accounts for the lag in measuring performance data. Given the difficulty and limited visibility in the earnings breakout, we did not parse out the specific components of addbacks to determine individual line-item realizations. As we have noted in our earlier studies, a portion of the difference between management projected and reported EBITDA could simply be on account of factors such as unmaterialized growth or unforeseen operational issues. The pandemic was particularly important for the 2019 cohort as it includes almost two full years of COVID-impacted results, 2020 and 2021.
• Second, we examined a broader set of data from deal inception for transactions originated from 2015-2021 to measure the magnitude and distribution of company-projected addbacks across major categories over time. This allows us to track and quantify the evolution of addbacks.

Our Ratings and Financial Risk Analysis metrics are derived from our own projections and judgments. While our findings serve as a reminder of the potential perils of taking overly optimistic management forecasts at face value, our ratings are based on S&P Global Ratings projections of a company's expected earnings, their capacity and appetite for debt repayment, and our analysis and assessment of business and financial factors such as management and board governance, projected synergies, or operating efficiencies.

All told, marketing leverage and the language around addbacks--as defined in debt agreements--are not determinants of our view of credit risk (other than in assessing covenant headroom when reviewing debt instruments containing financial maintenance covenants).

Part 1: The Validity And Accuracy Of EBITDA Addbacks

Do addbacks present a realistic picture of future profitability and risk, and do companies typically hit their forecast?

Deal arrangers, sponsors, and management teams continue to raise the bar in engineering and selling what qualifies as an addback. This has led to an increase in the number, types, and ultimately the magnitude of adjustments. For example, the COVID crisis created a whole new category of adjustments related to cost and revenue impacts stemming from the pandemic and related mitigation measures. In many of these cases, S&P Global Ratings views the ever-expanding definition of management-adjusted EBITDA as an inflation of profitability and an artificial deflation of leverage that contributes to understated valuation multiples, thereby improving the marketability of a transaction. The absence of a standardized definition of EBITDA is of critical importance here. In practice, it is and has always been a negotiated definition, varying from agreement to agreement.

While it is fine for individual investors to make their own judgments about how best to gauge EBITDA (and leverage, for that matter), it is still critical to understand the magnitude and persistence of the shortfall in marketing versus actual EBITDA. Further, investors should understand that an expansive definition of EBITDA in a company's debt agreements typically presents incremental event risk because it often provides additional headroom under negative covenants and restricted payments (including dividends, debt, investments, and lien allowances).

Summary of findings:

It is highly unusual for management teams to paint their projections as anything but conservative when marketing a transaction. But how do PitchBook projections translate compared to 10-K's or annual reports? Across all five cohorts in our study, only 4% of companies met or exceeded their earnings projections on a reported basis in the year following deal inception. Harkening back to our original study ("When The Credit Cycle Turns: The EBITDA Add-Back Fallacy", published Sept. 24, 2018), this "addback fallacy" has become institutionalized. In the latest cohort, we found yet again that both anticipated EBITDA and deleveraging expectations fell materially short of issuer projections for the two years that we tracked companies' performance after transaction origination (see Table 1). We repeated the performance gap analysis for M&A and LBO transactions that originated in 2015-2018, along with the 2019 transactions that we reviewed this year. Our analysis of the 2019 cohort showed that the magnitude of the misses was among the highest of the five cohorts in our study.

For the 2019 cohort of deals, 80% of the companies missed their EBITDA targets by at least 25% in the first full calendar year following inception (2020), decreasing to 60% in 2021. The median miss on earnings in 2020 and 2021 were 41% and 35%, respectively. We chose median metrics for comparison because we observed a fair amount of variation within each cohort and across the five sets of cohorts. However for the year 2020, we are cognizant of the setback companies had in realizing their EBITDA projections due to the pandemic.

Table 1

Table 2

Table 3

Table 4

Table 5

The following table is a composite of the five cohorts in our study. For the aggregate sample, we followed the same methodology of measuring projection performance for each of the individual cohorts--looking at the two full years following deal inception to measure the accuracy of management projections and the magnitude of the misses.

Table 6

Our review methodology:

To assess the realization of addbacks, we compared marketing EBITDA presented at deal inception with actual reported EBITDA. We compared at the aggregate level, given the difficulty in evaluating the various individual components of addbacks. For example, a company often does not disclose the actual achievement of a particular type of cost savings in its financials. Further, in the "new normal" covenant-lite loan environment, there is a lack of compliance certificates that can provide details on addback realization. We include two years of actual performance data--allowing time to gauge whether the company could achieve anticipated synergies--to permit certain cost addbacks (such as transaction fees and expenses and restructuring costs) to roll off.

Further, just like in our earlier reviews, we eliminated companies that underwent a material M&A or LBO transaction within two years of deal inception. This enabled us to remove distortion following subsequent transformative events (new debt issuance, earnings colored by subsequent acquisitions, etc.), which would render initial projections irrelevant. It also lets us cleanly compare reported EBITDA, debt, and leverage with what was projected by these companies at deal inception.

Lastly, we cannot disclose company names because management projections are confidential.

EBITDA still fell well short of management projections.

If companies performed in accordance with their marketing projections, one could expect to see a convergence between management projected and actual reported results as companies realize their anticipated earnings, one-time items fall away, and synergies are achieved. In actuality, we saw a material divergence. The deviation indicates unmaterialized growth projections, operating challenges, and unrealized synergies or unattained cost savings. The 2019 cohort had the highest average leverage miss at 4.5x in year two (2021) in the history of our study. The pandemic-induced recession was undoubtedly a contributing factor in the magnitude of the miss.

Chart 1

Table 7

Management failed to reduce debt as projected.

Failure to meet projected debt levels also contributed to the significant miss of managements' projected leverage, but to a much lesser extent than EBITDA misses. Virtually all issuers present a deleveraging story to the market at deal inception, stating intentions to sweep surplus cash to reduce debt. The latest two cohorts performed better and showed significant improvement over the prior three cohorts, where about 75% of companies missed their debt projections in year two, versus approximately 67% in the latest two cohorts (see Table 5).

In short, companies' intentions to apply surplus cash to pay down debt appear to be infrequently executed. Indeed, companies rarely, if ever, pay down debt to the extent indicated. All five vintages displayed a similar pattern: roughly two-thirds of companies kept debt levels in check (by keeping debt levels below their projections, or within 10% of their targets for projected debt) in the first year following origination. That share quickly deteriorated to less than half (average of 45%) by the end of the second year across all cohorts. We netted reported cash balances against reported debt to compute debt and leverage divergence for comparability, which was especially important in 2020 and 2021 as many companies retained high cash balances as a cushion against uncertainty during the COVID pandemic.

Chart 2

Table 8

Actual leverage far exceeds initial projections.

As a result, there is a material discrepancy between projected and reported leverage across the aggregate data set. We see a company's projections become increasingly aspirational on both ends, building a significant leverage cushion and presenting a case that does not necessarily represent credit realities. By averaging the median gap across the five vintages, companies under-projected leverage by an average of over two turns (2.2x) in the first year, increasing to 2.9 turns by the end of year two (see Table 6).

Chart 3

Table 9

The pandemic had an impact.

While the table above shows improvement year over year (YOY) for the 2018 cohort, with the leverage miss improving in 2020, our leverage calculations are based on net debt. When looking at reported (gross) debt figures for the 2018 cohort, the average projected debt miss went from 17% in 2019 to 73% in 2020 compared to 19% and 35% for the 2017 cohort. We believe this is due partly to COVID-related cash hoarding during the last the three quarters of 2020.

Part 2: The Magnitude And Composition Of EBITDA Addbacks

The data set for this part of our review is more extensive, encompassing 541 M&A and LBO transactions originated between 2015 and 2021 with deal sizes exceeding $50 million. It includes S&P Global Ratings-rated transactions and is limited to those where management provided us with a detailed bridge from reported EBITDA to marketing EBITDA (as is typically the case). This data set is larger than the set for Part 1 for two reasons: one, it includes transactions for 2020 and 2021 where we don't yet have enough operating results to gauge performance relative to management projections, and two, it includes transactions from prior years that we did not use for part one of this study because of a subsequent transformative transaction. Of the total sample, 56% were M&A transactions and 44% LBO transactions, and 87% by deal count were rated in the 'B' category at inception, with the remaining 13% in the 'BB' rating category. With the expansion of the data set to include transactions from 2021, the proportionate share of 'B' category ratings continues to grow, reflecting the erosion of credit quality in the broader leveraged finance market. Three-quarters of the transactions in the sample were sponsored and the remainder non-sponsored.

Chart 4A

Chart 4B

Chart 4C

We measured the magnitude of addbacks as a percentage of management's marketing EBITDA and pro forma LTM EBITDA excluding any addbacks, as presented at transaction inception. On average, over the past seven years, addbacks made up over 29% of marketing EBITDA, and over 52% of LTM reported EBITDA (see Chart 5). Over the period, this forward-looking measure of addbacks as a percent of marketing EBITDA has grown marginally each year, exceeding 30% in 2018 and beyond from 24% in 2015.

Across the seven-year sample, the ratings distribution has shifted toward 'B' rated issuers. We found that regardless of transaction type, 'B' category credits led their higher-rated 'BB' counterparts in the average adjustment amount.

Chart 5

Synergies and cost savings made up about a third of total addbacks.

Expected synergies and cost savings continue to be the largest components of addbacks. Chart 6 sorts the general addback adjustments into six broad categories. Each year, synergies and cost savings led over other adjustment types. It peaked in 2016 at nearly 39%, with a seven-year average of 29%. Synergies are often the most difficult of the common addbacks to project accurately. As mentioned earlier, we rarely factor the full amount of management-anticipated synergies into our projections. Instead, we have detailed discussions with management teams and their advisors regarding expected synergies and adjust for what we believe to be achievable and when such achievement is likely. It often depends on the source of synergy and, when relevant, whether a company or sponsor has a demonstrated track record in realizing similar synergies or cost savings from past transactions. While some are easier to execute--such as eliminating overlapping corporate overhead to achieve labor savings--others fall outside management's control. Pro forma saving on procurement offers one example, as it requires contract negotiations with various third-party vendors. Lastly, some synergies are costly to implement, requiring an upfront expense, such as severance pay.

Restructuring costs are another area of disparity in treatment. We generally treat ongoing restructuring charges as operating costs because most companies need to restructure their operations to adapt to changing environments and remain competitive. Similarly, as stated in our approach to EBITDA, management fees constitute a cash operating cost and are treated as such in our analysis. For this reason, we do not add back restructuring costs or management fees in our calculation of adjusted EBITDA. In addition, this body of data demonstrates how far off companies' original assumptions tend to be about the future realization of addbacks.

Chart 6

Technology and health care had the highest addbacks as a percentage of marketing EBITDA.

The Technology, Healthcare, and Media, Entertainment, and Leisure sectors had the most addback-inflated EBITDA when comparing the seven-year average of total addbacks to company marketing EBITDA at deal inception at 36%, 35%, and 35%, respectively. Those three sectors buoy the entire sample, representing 44% of the deal count.

Table 10

Chart 7

The degree of EBITDA addbacks at inception impacts magnitude of projection miss.

Our data show there appears to be a positive correlation between the magnitude of EBITDA addbacks at deal inception and the severity of management misses of projected leverage versus actual reported leverage. We consolidated the five cohorts of data in Part 1 of this analysis, providing a sizeable sample of close to 180 transactions. For the aggregate sample, we followed the same methodology of measuring projection performance for each of the individual cohorts--looking at the two full years following deal inception to measure the accuracy of management projections and magnitude of the misses. We then mapped the magnitude of addbacks to each of those transactions on the intuitive supposition that the greater the addbacks, the bigger the miss. Charts 8 and 9 below map this relationship for year 1 and year 2; respectively. Focusing on the two extremes in both years of performance data (leverage miss of <1x and >5x), which comprise a significant portion of the sample, our data shows that addbacks were approximately double for the worst performing transactions.

Chart 8

Chart 9

Table 11

'B'-rated companies typically include more addbacks than 'BB'-rated companies.

In our sample of 541 transactions originated between 2015 and 2021, 87% were rated in the 'B' category. Our study shows that these companies have consistently underperformed 'BB' category credits ('BB-', 'BB', and 'BB+') in projecting earnings. The need for aggressive adjustments to make a deal marketable is likely lower for 'BB' rated companies as their pro forma leverage is typically lower, so it is probable that the addbacks tend to be less aggressive or aspirational. In addition, an intuitive view could be that lower-rated credits tend to be smaller and have higher earnings volatility, making projections more difficult. Also, financial sponsor ownership is more common among lower-rated entities than those in the 'BB' category and our data detailed below show that sponsor-owned companies tend to be more aggressive, particularly when projecting earnings.

For the 'B' category credits in our latest cohort, the median reported leverage is 2.6 turns higher than projected in 2020, with the gap widening to 2.7 turns in 2021. 'BB' category credits performed better, missing by 1.6 turns in 2020, increasing to 1.8 turns in 2021. This analysis further reinforces the significant credit disparity between 'B' and 'BB' credits.

Table 12

Chart 10

Chart 11

LBO transactions show bigger leverage projection misses than M&A transactions.

Consistent with our prior studies, LBO and M&A transactions are comparable in the amount of addbacks as a percentage of marketing EBITDA, at 27% and 30%, respectively. However, the distribution of addbacks differs. As one would expect, M&A transactions showed above-average addbacks for synergies and cost savings as these are often a selling point of the transaction, accounting for about 30% of addbacks versus 27% for LBOs.

Regarding projection performance, LBO transactions have consistently underperformed M&A deals in terms of projecting leverage for every cohort in our study. In the latest cohort, M&A transactions missed by 1.7x in 2020 and 2.3x in 2021, and LBOs missed by 2.7x and 2.8x. For comparison, within our financial risk categories, the difference between the midpoints of two different categories (significant and aggressive, for example) is 1.0 turn of leverage.

Table 13

Chart 12

Chart 13

Sponsored transactions underperform nonsponsored transactions.

Our study of over seven cohorts over the years on the magnitude and composition of addbacks shows that sponsored transactions tend to be more aggressive with addbacks versus nonsponsored deals, but not by a significant margin. The seven-year average for sponsored deals was 29% versus 27% for non-sponsored. Nonsponsored deals were generally about 25% each year with little fluctuations, except for deals originated in 2021 when non-sponsored transactions averaged 36% versus 31% for sponsored. Of the 541 transactions in our data set, 407 were sponsored, 134 were not.

We also noted a significant disparity by sponsor in terms of their aggressiveness in the use of addbacks. We looked at the 39 sponsors that had done at least 4 transactions in our data set. Of those, the 10 most "aggressive" firms (accounting for 74 transactions) had addbacks averaging 44% of marketing EBITDA. Conversely, the 10 least aggressive sponsors (accounting for 55 of the transactions) averaged 16%.

Chart 14

Tables 14 and 15 show that sponsored transactions significantly underperformed nonsponsored transactions in the accuracy of their projections at deal inception. For the 2019 cohort, the median leverage miss for sponsored deals in 2020 was 2.6 turns, increasing to 2.7 turns in 2021. For nonsponsored deals the median miss was 1.7 turns in 2019 and 1.8 turns in 2021.

Table 14

Table 15

Conclusion: Buyer Beware

Our five-year study paints a compelling portrait of the dubious nature of addbacks and use of company-adjusted EBITDA as a proxy for future profitability. Our substantial dataset makes it clear that management teams and equity sponsors regularly miss their projections by a large margin, and that the magnitude of the misses are positively correlated with the level of addbacks and negatively correlated with the company's issuer credit rating (misses are larger for lower-rated firms). This suggests that inflated addbacks may help companies with higher financial risk get deals done. We hope this information is useful to investors in their own due diligence and credit committees. The track record of management teams and sponsors is an important consideration by our sector analysts in constructing our own independent projections.

It's also important to understand that larger addbacks may also create higher future event risk because company-adjusted EBITDA often defines the size and flexibility companies have to take actions under debt agreements, which may weaken credit quality (through various free and clear baskets and incurrence tests that define a company's ability to add debt, pay dividends, transfer assets, etc. as well as by weakening the springing financial maintenance tests on revolving credit facilities).