When investors last month thumbed through the voluminous marketing materials from Blue Nile, the US online jeweller being taken private by Bain Capital, a few numbers — and footnotes — stood out.
Blue Nile was seeking to raise $180m of debt to fund the $500m private equity takeover.
By one measure, Blue Nile’s debtrepresented roughly four times its adjusted earnings before interest, taxes, depreciation and amortisation of $45m. But by another, the actual reported ebitda of about $19.3m, leverage was 9.3 times, according to one investor briefed on the presentation.
Turn to page 71 of the marketing document and the footnotes reveal the differences between those two numbers: the $45m figure excludes employee stock compensation, public company costs, compliance and regulatory filing fees that will disappear following Bain’s takeover.
However, it also included items that are no more than future hopes, such as cost savings from better sourcing as well as improved margins for Blue Nile.
The latter are examples of so-called ebitda “add-backs”, which make companies appear more creditworthy.
At a time when money is pouring into junk bonds and the leveraged loan market is red hot, the more aggressive and creative use of add-backs suggests that buyers of the debt are losing discipline over the credit risk they are taking on.
The prospect of rising US interest rates has propelled investors into the bank loan market, where private equity firms raise money to fund their buyouts. The bank loan market has counted 12 consecutive weeks of inflows, according to data provider Lipper.
“Most of the time, the bank’s add-backs are understandable and reasonable. When the loan market is hot they tend to be a little more aggressive,” says Vinny Ingato, a portfolio manager at investment manager ZAIS Group.
Investors typically give credit for non-cash items and understandable cost reductions generated when a company goes private. The contentious debate is around the set of add-backs that relate to recognising future cost savings not set to materialise for a year or two down the road.
‘’Our job is to make our own adjustments,’’ says Mr Ingato. “We try to come up with a real cash flow. But it is disingenuous to say something is a real cash expense and then add it back.”
Companies and their bankers selling the debt argue that such “normalised” measures of ebitda offer the most realistic view of a company’s ability to service their borrowing.
Yet as add-backs in the past three years have become an accepted part of the loan syndication process, more aggressive adjustments to ebitda have left investors a tricky task in sorting out what costs ultimately have a bearing on future profits.
In 2013, two primary bank regulators, the Office of the Comptroller of the Currency and the Federal Reserve, released guidelines on leveraged loans and identified deals that led to leverage of more than six times as excessively risky.
Yet banks and private equity firms quickly learned that ebitda enhanced by add-backs could sometimes push otherwise questionable loans past regulatory scrutiny.
David Daigle, a portfolio manager with Capital Group, says: “The bankers and issuers can inflate their adjusted ebitda numbers all they want but we will do our own work on what we think the available cash [to service debt] is. Anyone buying off adjusted ebitda numbers needs to be very careful.”
Ebitda is often considered a shortcut measure of cash flow and a company’s ability to service debt, despite the fact it does not account for capital expenditures or working capital needs. A company’s leverage is typically represented by both debt to ebitda and ebitda to interest expense ratios.
Add-backs can cloud those ratios and present trouble if a company has covenants that limit additional debt or dividend issuance based on the figure, says Mr Daigle.
“The important consequence of having an inflated adjusted ebitda number is that all the provisions key off that number,” he adds. “You are opening up more financial flexibility to lever the company up more.”
While the “adjusted” earnings statements that listed companies make when they release earnings have drawn the scrutiny of US securities regulators, marketing memos drafted by banks and private equity firms are free to highlight their preferred metrics, as long as they provide a reconciliation to figures that comply with accounting standards.
Credit rating agency Moody’s notes that add-backs are often used as a proxy for unlevered operating earnings or earnings before debt costs and can be used to gain access to the debt market during “periods of low risk tolerance”.
Conventions vary by industry. Retailers often add-back costs for store openings. As technology buyouts have proliferated in recent years, the tech sector’s unique bookkeeping is rife for tinkering.
One private equity executive notes how companies now shift charges on software development costs away from the income statement. Additionally, he cites how a metric called “cash ebitda” has emerged.
Cash ebitda is typically higher than conventional ebitda because software-as-a-service businesses may defer the accounting recognition of revenue even if cash had been collected.
However, there are now signs that the backdrop for add-backs may be changing. It has been reported that regulators at the Fed were concerned over the riskiness of a loan that banks arranged to fund the buyout of the Ultimate Fighting Championship, allowing KKR to recently step in to reprice the loan.
“There is a lot of political pressure at the banks not be called out [by the OCC/Federal Reserve],’” says a lawyer who represents private equity firms.‘’There is a lot of back and forth between banks and investors to get them defensible.”
