'Fake Ebitda' masks risk in debt-laden companies, says report

During the days of easy money, one of the most widely tracked numbers in credit markets became an unfortunate punchline.

Ebitda, which stands for earnings before interest, taxes, depreciation and amortization — a figure that’s akin to a company’s cash flow and, thus, its ability to pay its debts — was instead mocked as a marketing gimmick. When bankers and private equity firms asked investors to buy a piece of their loans funding buyouts and other transactions, they would layer on so-called add-backs to earnings projections that, to some, defied reason.

“Ebitda: Eventually busted, interesting theory, deeply aspirational,” one Moody’s analyst joked in 2017. Sixth Street Partners co-founder Alan Waxman had a more blunt assessment, warning an audience at a private conference that such “fake Ebitda” threatened to exacerbate the next economic slump.

Now, amid rising interest rates, persistent inflation and warnings of a potential recession on the horizon, research from S&P Global Ratings is underscoring just how far from reality the earnings projections are proving to be.

As Bloomberg’s Diana Li wrote on Friday, 97 per cent of speculative-grade companies that announced acquisitions in 2019 fell short of forecasts in their first year of earnings, according to S&P. For 2018 deals, it was 96 per cent and 93 per cent for 2017 acquisitions. Even after the economy was flooded with fiscal and monetary stimulus after the pandemic, about 77 per cent of buyouts and acquisitions from 2019 were still short of their projected earnings, S&P’s research shows.

The bigger worry is that years of rosy earnings projections is masking the amount of leverage on the balance sheets of the lowest-rated companies. 

By 2019, before the Covid-19 pandemic sent markets tumbling the following year, add-backs were accounting for about 28 per cent of total adjusted Ebitda figures used to market acquisition loans, Covenant Review data at the time showed. That was up from 17 per cent in 2017.

The S&P analysts this week said the latest data reinforces their view that those Ebitda figures are “not a realistic indication of future Ebitda and that companies consistently overestimate debt repayment.”

“Together, these effects meaningfully underestimate actual future leverage and credit risk,” they wrote.