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Our latest analysis of company-adjusted EBITDA continues to show that U.S. speculative-grade corporate issuers typically present unreliable and overly optimistic earnings, debt, and leverage forecasts in their marketing materials when launching deals. In the absence of a standardized definition of EBITDA, addbacks can create challenges for investors by inflating EBITDA, which can understate debt leverage and expand the flexibility embedded in debt documents to add debt or make restricted payments. S&P Global Ratings bases its ratings on its independent projections of a company's expected earnings.

What We're Watching

Our sixth annual analysis of EBITDA addbacks reinforces our view that companies' EBITDA adjustments at the inception of a deal generally don't provide a realistic view of their future earnings. We continue to find a positive correlation between the magnitude of addbacks at deal inception and the severity of projection misses.

This is crucial for investors to understand because addbacks represent a significant percentage of management-adjusted EBITDA at deal inception, at approximately 30% on a median basis over the study's 2015-2020 span.

In our analysis, we assessed the relationship between the magnitude of addbacks (which are adjustments to income and cash flow, for operating costs characterized as nonrecurring, unusual, or discretionary, or projected earnings boosts from cost savings or synergies) and projected earnings performance (as measured in terms of projected leverage misses over the two years following deal inception).

The results of our studies over the last six years show that company-adjusted EBITDA continues to show a vast difference between management projections and what companies actually report.

During the first year following deal inception, historically 95% of the companies failed to meet their forecasts, debt was understated across the six-year sample by 2%, and management missed leverage projections on a median basis by 2.3x. In the second year, over 50% missed earnings projections by more than 33%, the median miss in projected debt rose to 13%, and actual leverage exceeded management projections by 2.7x.

Notwithstanding a slight reduction in the magnitude of misses in our latest study, aggressive addbacks correlate to persistently unreliable projections. As a result, management-adjusted EBITDA is generally an unrealistic view of future profitability.

What We Think And Why

Data for the latest cohort of borrowers showed a slight improvement in managements' earnings projections. Whether this is an anomaly or an early sign of a fundamental shift toward more realizable projections at deal inception is up for debate--as is the reason for the notable improvement. While we've seen some variation around the baseline in our previous studies, this iteration featured the first notable decline in miss percentage, with 2020 transactions showing marginal improvement in accuracy.

The most recent cohort in our six-year study represents a small portion of our aggregate dataset and may not necessarily represent a change in management mindset.

The latest cohort's origination during the height of the COVID-19 pandemic, when investors were in "risk-off" mode, is likely a potential driver. It's also possible that companies, whether consciously or otherwise, were inclined to make more accurate projections at that time because lenders were especially eager to spot projections that were (or appeared) unattainable.

Either way, our findings clearly warn of the potential perils of accepting management forecasts at face value. Because the absence of a standardized definition of EBITDA can create challenges for investors directly comparing transactions, unrealistic projections may weaken credit quality--and elevate the potential for significant future event risk.

We base our ratings on our independent projections of a company's expected earnings, a tempered view of its capacity and appetite for debt repayment, and our analysis and assessment of business and financial factors (such as management and board governance). Marketing leverage and deal-specific language around addbacks don't determine our view of credit risk (other than in assessing headroom regarding financial-maintenance covenants). There's often a vast difference between management projections and our own projections.

What Could Change

The addition of the 2021 cohort of companies in our study next year will be telling, given the dramatic swing in credit market and economic sentiment and robust issuance volumes in that year--especially since market dynamics may have already evolved.

We will also be watching to see whether the heightened competition between syndicated and private leveraged credit markets since 2020 leads to looser underwriting standards and affords borrowers more flexibility to pad EBITDA addbacks.

It's possible that the persistently large underperformance could lead to a tempering of addbacks. Nonetheless, this appears unlikely, given limited lender negotiating power to dictate document terms (in syndicated credit markets, at least).

There is a greater chance that we will continue to see sizable EBITDA addbacks, persistent underperformance of actual EBITDA relative to projections, and variation around the baseline depending on the underlying credit market and economic conditions in any given year.

Writers: Joe Maguire and Molly Mintz