S&P Global Ratings' sixth annual analysis of EBITDA addbacks continues to show that:

• Addbacks represent a significant percentage of management-adjusted EBITDA at deal inception (30% on a median basis over the life of the study); and
• Management projections are aggressive, further substantiating that generally U.S. speculative-grade corporate issuers present earnings, debt, and leverage projections in their marketing materials at deal inception that they cannot realize, indicated by our study showing median leverage misses of 2.3 turns in year one following deal inception and 2.7 turns in year two.

As one would expect, these two factors are not mutually exclusive. Our data shows that, in general, aggressive addbacks correlate to increasingly unreliable projections. Our latest study reinforces our view that EBITDA adjustments do not generally provide a realistic view of future earnings.

We illustrate the relationship between the magnitude of addbacks--adjusted expenses to income and cash flow, such nonrecurring, unusual or discretionary costs--and projection performance as measured in terms of projected leverage misses in the two years following deal inception (Charts 1 and 2) for six years of performance data for transactions originated from 2015-2020 Focusing on the two extremes in both years of performance data (leverage misses of less than one turn and greater than five turns), which compose a significant portion of the sample, addbacks as a percentage of management-adjusted EBITDA (which we refer to as "marketing EBITDA") were approximately double for the worst performing transactions.

Chart 1

Chart 2

We are also introducing an interactive dashboard that enables readers to explore the data more immersively. It offers a deep analysis of the data from our six-year study here.

Our analysis consists of two main components:

• In the projection performance section of this report, we compare issuers' projected EBITDA at deal inception with actual reported EBITDA for the two fiscal years following the year of origination, accounting for the lag in measuring performance data in our study. Specifically, it provides time for one-time items to fall away and for management to realize most projected synergies. Given the difficulty and limited visibility in earnings breakouts, we are not in a position to parse out the specific components of addbacks to determine individual line-item realizations. As in our earlier addback studies, other factors besides overstatements may contribute to the difference between management-projected and reported EBITDA, such as unmaterialized growth or unforeseen operational issues.
• Part two of the study focuses on the magnitude and distribution of addbacks. We track and quantify the evolution of addbacks over time. Of the six categories of addbacks we track, synergies are the largest component by a wide margin. Often esoteric, synergies are also the most difficult to predict and model.

S&P Global Ratings' projections are independent

We derive ratings and financial risk analysis metrics from our own projections and judgments. While our findings clearly warn of the potential perils of buying into management forecasts, we base our ratings on S&P Global Ratings' independent projections of a company's expected earnings, a tempered view of its capacity and appetite for debt repayment, our analysis and assessment of business and financial factors such as management and board governance, and our view of potential synergies or operating efficiencies.

Specifically, marketing leverage and deal-specific language around addbacks--as defined in debt agreements--do not determine our view of credit risk (other than in assessing covenant headroom when reviewing debt instruments containing financial maintenance covenants). See an overview of our approach to EBITDA in our analysis in the About Our Analysis section below.

Part 1: The Validity And Accuracy Of EBITDA Addbacks

Addbacks can muddy the picture for future profitability and risk, and whether companies typically hit their forecasts

Deal arrangers, sponsors, and management teams remain aspirational in including various adjustments that they classify as EBITDA addbacks. This has increased the number, types, and ultimately magnitude of adjustments common in marketing materials and debt agreements. For example, while we have yet to see a literal addback for the "kitchen sink", the COVID-19 pandemic and related mitigation measures created a whole new category of adjustments related to cost and revenue impacts. In general, S&P Global Ratings views the ever-expanding definition of management-adjusted EBITDA as an inflation of profitability and an artificial deflation of leverage. This understates valuation multiples and improves the optics and marketability of a transaction. The absence of a standardized definition of EBITDA is critically important and can make it challenging for investors to directly compare transactions.

In practice, it is and has always been a negotiated definition, varying from agreement to agreement. The lack of lender negotiating leverage in the syndicated loan market has helped addbacks proliferate. While we understand anecdotally that lender pushback on certain adjustments and terms can sometimes be effective at the margin, this largely ebbs and flows with supply and demand. Terms are now generally more permissive.

While investors should make their own call about how best to gauge EBITDA and deal leverage, it is still critical that they understand the magnitude and persistence of the shortfall in projected versus actual EBITDA, which our study underscores. Further, investors should be sensitive to an expansive definition of EBITDA providing for myriad addbacks in debt agreements. This may well present significant incremental event risk because it often provides additional headroom under negative covenants and restricted payments (including dividends, debt, investments, and lien allowances). The expansive definition of EBITDA has contributed to the rise in aggressive out-of-court restructurings in recent years.

Summary of findings

Management teams almost universally claim there is ample upside to their projections at deal inception and that the base case they market is conservative. However, our six-year performance study suggests this is far from reality. According to our data, 95% of the companies failed to meet their first-year projections and over 50% missed earnings projections by more than 33% in the two years following inception.

Over-promised debt repayment also contributed to the overall leverage misses, but to a lesser degree. The median miss in projected debt in the six-year study is 2% in year one and 13% in year two following deal inception. For the more than 200 transactions, management missed leverage projections on a median basis by 2.3x in year one and 2.7x in year two. We delve into greater detail in this report.

Table 1

Table 2

EBITDA misses are the primary driver behind large leverage misses

If management projections proved realistic, we would see a convergence between management-projected and actual reported results as companies realize anticipated earnings, one-time items fall away, and synergies are achieved. In actuality, our study continues to show a rather dramatic divergence. In addition to management-inflated EBITDA, we could attribute the deviation in part to several additional factors, including unmaterialized growth projections, operating challenges, unrealized synergies, or unattained cost savings.

Our six-year study shows that just 5% of companies met or exceeded projections in the first year following deal inception and 16% in year two. The median miss in year one was 34%, rising to 35% in year two (Table 3).

The 2020 cohort improved performance, with 11% of companies meeting or exceeding projections in 2021 and 30% in 2022. The median miss improved by 6% to 28% in 2021 versus the six-year median of 34% and improved by 7% in 2022 to 28% versus the six-year median miss of 35% in year two. The average miss improved 7% in year one and 13% in year two.

Still, while results for 2020 are encouraging, one year does not necessarily represent a fundamental shift toward more reasonable management forecasts.

Table 3

Chart 3

Debt reduction is lower than projected

Failure to meet projected debt also contributed to the significant miss of management-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 aggressively reduce debt. Relative to the six-year sample, the latest 2020 study cohort decreased projection accuracy with respect to anticipated debt. The median miss for the 2020 cohort was 12% in 2021 versus the six-year median miss of 2% in year one. That rose to 34% in 2002 versus the six-year median miss in year two of 13%. This actually almost fully offset the improvement in earnings projections, resulting in leverage misses that were almost on top of our six-year average.

In short, companies appear to have infrequently executed stated intentions to apply surplus cash to pay down debt. Indeed, they rarely, if ever, meet those indications. Across the six vintages, 60% of companies kept debt in check (by keeping below or within 10% of their targets) in the first year following origination. That share quickly deteriorated to less than 27% by the end of the second year across all cohorts. We net reported cash balances against reported debt to compute debt and leverage divergence for comparability.

The six-year median (across the 209 transactions from all six cohorts) debt repayment miss was 2% in year one and 13% in year two. The 2020 cohort performed significantly worse than the six-year median, missing by 12% in year one and 34% in year two due to several outliers.

Table 4

Chart 4

The resulting leverage profile is much higher than projected

The combination of significant misses in earnings and debt projections, particularly earnings, creates a material discrepancy between projected and reported leverage across the six-year sample. Aspirational management-projected EBITDA creates a significant leverage cushion inconsistent with credit realities. By averaging the median gap across the six vintages, companies under-projected leverage by an average of 2.3 turns in the first year, increasing to 2.7 turns by the end of year two (Table 5).

For the 2020 cohort, the median leverage miss outperformed the six-year median in year one at 2.1 turns versus 2.3 turns. Conversely, in year two, the median miss was three turns, compared to the six-year median of 2.7. We primarily attribute this to the uncharacteristically large debt miss in 2022 for the 2020 cohort.

Table 5

Chart 5

Part 2: The Magnitude And Composition Of EBITDA Addbacks

Data set

The sample size for our EBITDA addback magnitude and composition analysis encompasses over 600 broadly syndicated mergers and acquisitions (M&A) and leveraged buyout (LBO) transactions that we rated, originating from 2015-2022. This includes only those transactions for which management provided us with a detailed bridge from reported EBITDA to marketing EBITDA (as is typically the case for large LBOs and M&A). This data set is substantially larger than the set for Part 1 because it includes:

• Transactions for 2021 and 2022 for which we don't yet have the two years of operating results to gauge projection performance.
• Transactions from prior years that we did not use for Part 1 due to a subsequent transformative transaction.

Of the total sample, 56% were M&A and 44% LBOs. We rated 87% in the 'B' category at inception, with the remaining 13% in the 'BB' category. With the expansion of the data set to include transactions from 2022, the proportionate share of 'B' category ratings continues to increase, reflecting the erosion of credit quality in the broader leveraged finance market. Finally, more than three-quarters of the transactions in the sample were sponsored and the remainder non-sponsored.

Chart 6A

Chart 6B

Chart 6C

We compared the magnitude of addbacks to both last-12-months reported EBITDA excluding addbacks and management-adjusted EBITDA including addbacks at deal inception. On average, in the eight years of EBITDA magnitude data in our study, addbacks made up over 29% of marketing EBITDA and about 53% of last-12-months reported EBITDA (Chart 7). The most recent 2022 cohort was right on top of the eight-year average of 29%. This forward-looking measure has marginally expanded each year, exceeding 30% in 2018 and beyond from 24% in 2015.

Our data across the eight-year sample shows the ratings distribution has shifted toward 'B' rated issuers. We found that regardless of transaction type, 'B' category credits lead 'BB' rated issuers in average adjustment. The line of demarcation is the 2018 cohort of transactions. In the 2015-2017 cohorts, 'BB' category ('BB-', 'BB', and 'BB+') transactions accounted for an average of 20% of the data set. From 2018-2022, 'BB' category credits averaged about 10% of the sample. The 2022 cohort contained only one 'BB' category issuance.

Correspondingly, average addbacks as a percentage of management adjusted EBITDA rose to over 30% from about 25% in 2015-2017.

Chart 7

Synergies and cost savings make up about a third of total addbacks

Expected synergies and cost savings are the largest components of addbacks. We sort the general addback adjustments into six broad categories (Chart 8). In every cohort but the latest, synergies and cost savings lead over other adjustment types. It peaked in 2016 at nearly 39%, with an eight-year average of 28%. Synergies are often the most difficult of the common addbacks to forecast accurately. As mentioned, we rarely factor all of management-anticipated synergies into our projections. Our assessment includes detailed discussions with management teams and their advisers regarding expected synergies and timelines for realization. Our adjustments often depend on the source of synergies and, when relevant, whether a company or sponsor has a track record of realizing similar synergies or cost savings.

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 for which we also must account.

Restructuring costs are another area of disparity in treatment. We generally treat these ongoing 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 we treat them as such in our analysis. Therefore, we do not add back restructuring costs or management fees to our calculation of adjusted EBITDA. In addition, this body of data demonstrates how far off companies' original assumptions tend to be about the realization of addbacks. We include all negotiated addbacks in our study.

Chart 8

Technology, health care, and media, entertainment, and leisure stand out with high addbacks as a percentage of marketing EBITDA

These sectors consistently have high addback-inflated EBITDA, with an eight-year average of about 35% of total addbacks divided by company-adjusted pro forma EBITDA at inception. Addbacks for these sectors buoy the entire sample given the disproportionate representation of about 44% of the deal count.

Table 6

Chart 9

Table 7

Companies rated 'B' typically include more addbacks than those rated 'BB'

In our data set, we rated 87% companies in the 'B' category. Our study shows that these companies have consistently underperformed 'BB' category credits in projecting earnings. The need for aggressive adjustments to make a deal marketable is likely limited for 'BB' rated companies since their pro forma leverage is typically lower. 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. Sponsor-owned companies tend to be more aggressive when projecting earnings.

Across the six-year sample, the median leverage miss in the 'B' category was 2.6 turns higher than projected in year one following deal inception, with the gap widening to 2.9 turns in year two. Credits in the 'BB' category performed significantly better, missing by 2.2 turns in year one and 2.3 turns in year two, further reinforcing the significant credit disparity between 'B' and 'BB' credits. The comparison for the latest 2020 cohort is not meaningful because the sample contains only one 'BB' category issuance.

Table 8

Chart 10

Chart 11

LBO leverage projection misses are larger than for M&A transactions

Consistent with our prior studies, they are comparable in addbacks as a percentage of marketing EBITDA--28% for LBOs and 31% for M&A. However, the distribution of addbacks differs. M&A transactions show above-average addbacks for synergies and cost savings, since these are often a selling point of the transaction.

Regarding projection performance, LBOs have consistently underperformed M&A deals in projecting leverage for every cohort in our study. On a median basis, M&A transactions missed by 1.9 turns in year one and 2.2 turns in year two following deal inception; LBOs missed by 2.6 turns in year one and 3.3 turns in year two. The gap increased in the latest cohort with LBOs missing more than M&A transactions by 0.9 turns in 2021 and 1.3 turns in 2022. For comparison, within our financial risk categories, the difference between the midpoints of two categories (significant and aggressive, for example) is one turn of leverage.

Table 9

Chart 12

Chart 13

Sponsored transactions generally underperform non-sponsored transactions

They tend to be more aggressive, according to our data, but not by a significant margin. Projection performance is a different story, however (Chart 14). The eight-year average for sponsored deals was 29% versus 27% for non-sponsored deals. The latter were generally about 25% each year with little fluctuation, except for deals that originated in 2021 when non-sponsored transactions averaged 36% versus 31% for sponsored. We attribute this to one extreme outlier in the non-sponsored sample. Removing that transaction results in an average of 29%, which is more consistent with other cohorts. Of the 604 transactions in our data set, 459 were sponsored, 145 were not.

We also noted a significant disparity by individual sponsors regarding their aggressiveness in the use of addbacks. We looked at the 39 sponsors that had done at least four transactions. Of those, the 10 most aggressive firms (accounting for 75 transactions) had addbacks averaging 44% of marketing EBITDA. Conversely, the 10 least aggressive sponsors (accounting for 58 transactions) averaged 16%.

Chart 14

Sponsored transactions significantly underperformed non-sponsored transactions in the accuracy of their projections at deal inception (Tables 10 and 11). Our six cohorts of data show that the median miss for sponsored transactions was 2.7 turns in the year following deal inception, increasing to three turns in year two. This compares to a median miss for non-sponsored deals of 1.6 turns in year one and 1.7 turns in year two. For the 2020 cohort, the disparity was much wider than the historical median differential. Although the year one miss for sponsored transactions was slightly inside the longer-term median, the year two miss was 1.6 turns worse. Conversely, non-sponsored deals in the 2020 cohort outperformed the six-cohort median by a half turn in year one and 0.3 of a turn in year two.

Table 10

Table 11

Conclusion: Inflated Addbacks Illustrate Overall Weak Creditor Protections

Weakened protections and loose loan documentation are front and center in almost all outreach discussions we have with investors. Expansive EBITDA definitions resulting in egregious addbacks are a significant contributing factor. Such addbacks can certainly create higher future event risk because company-adjusted EBITDA often defines the size and flexibility companies have to take actions under debt agreements. This 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 the springing financial maintenance tests on revolving credit facilities. A company with negative reported EBITDA could incur significant incremental debt due to the definitional construct of EBITDA.

Our six-year study continues to underscore that addbacks and company-adjusted EBITDA are a poor predictor of 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 is positively correlated with addbacks and firms that we rate lower. This suggests that inflated addbacks may help companies with higher financial risk get deals done.

About Our Analysis