Ebitda: creative accounting did not end when debt was initially sold

Accounting shenanigans that help companies raise money have a habit of reappearing in different forms.

For years, corporate borrowers, often private equity-owned, have relied on so-called adjusted ebitda in order to maximise their debt-raising capability. These fudges included so-called “add-backs” — one-time charges and the like — designed to give a fairer depiction of profitability. But some dubious add-backs included earnings that were speculative or not-so-aberrational. Juicing up ebitda this way enabled the company to take on even more junk loans and junk bonds.

The holders of such debt are getting another accounting lesson now. Many of those previous debtors seek to borrow additional cash, deploying the fuzzy math of ebitda profitability. According to a recent report from Moody’s, of 226 leveraged loan term sheets it reviewed for debt issuances in 2021 and 2022, over half lacked formal definitions for ebitda. This has allowed corporates keen to raise more debt, or pay out dividends, to creatively construct an ebitda measure that avoids breaching covenants.

Some adjustments look defensible, such as those based on wording from Big Four accounting firms that write “quality of earnings” reports. Still these numbers still do not equate with the audited historical figures in financial statements. More questionable add-backs include the profits from merger and acquisition deals contemplated but not yet completed and research and development charges that are usually regularly recurring.

Credit agreements historically contained “maintenance” covenants, which would result in a technical default if a company failed to maintain a certain amount of profit relative to debt. Such restrictions have appeared less frequently in the last decade.

However, more common are “incurrence” covenants that have requisite profit levels before raising more debt or pursuing other financial engineering. The increasingly fluid ebitda calculation is one aspect of the creativity employed by borrowers to raise more money. Lenders, including sophisticated hedge funds, are ostensibly victims of this game-playing. Then again, they freely bought this paper ignoring the risks they took on.