Concerns Raised Over Credit Rating Agencies’ Assessments of EBITDA ‘Add-Backs’

After the Financial Crisis, once the actions of the leading credit rating agencies were brought to light, the sense of scepticism and suspicion regarding the actual operating policies of the agencies was at an all-time high. As such, a number of their practices have been scrutinised by onlookers with the view of determining their usefulness, their role, and their overall worth. The most recent example of this can be seen in the recent concerns raised within the business media, and from across the marketplace within certain sectors, regarding how the agencies are viewing something known as ‘add-backs’. In this post we will learn more about these concepts, and evaluate the concerns and their validity.

In May, Reuters ran with a story entitled ‘US investors sound alarm over projected add-backs’, whilst only on Friday the Financial Times ran with the headline ‘“Add-backs” stoke fears of distorted credit ratings’. The rating agencies have responded to this issue, with S&P publishing a research article in September entitled ‘When the cycle turns: The continued attack of the EBITDA Add-back’. So, before we assess the issues being raised, it is worth starting from a simple footing. EBITDA stands for ‘earnings before interest, taxes, depreciations, and amortization’, and is a measure of a company’s overall financial performance. In essence, we can think of this as a company’s ‘pure earnings’. However, even a simple definition of the concept has attached to it clear warnings, like ‘it can be misleading because it strips out the cost of capital investments like property, plant, and equipment’. The concept was said to have been developed by John C. Malone, current Chairman of Liberty Media (owners of Formula 1, amongst other things) in the 1970s ‘as a means of convincing investors that, despite a lack of profits, his company TCI was generative’. So, in theory, it seems to be, at least, a useful measure of company performance. However, concerns have been raised regarding the manipulation of such figures. The FT presents a hypothetical scenario as an explanation, whereby a fictitious company needs funding but the lender requires the company to have $10m of savings, which it does not have. In order to obtain that funding, the company could ‘add-back’ some costs – like travel expenses turning into non-recurring costs, company vehicles turning into an R&D expense, and so on – until those costs get ‘added-back’ to the EBITDA number, meaning that the company’s debt-to-ebitda ratio rises to the level which the lender requires. Whilst crude, the scenario is apparently not far from the truth, with UBS reporting that the average acquisition in 2018 had a debt-to-ebitda ratio of 5.6 times, but when add-backs were excluded this figure shot up to 7.4.

The fears examined in May suggested that investors in leveraged loans, used for leveraged buy-outs (LBOs) were concerned that companies’ usage of add-backs could cause companies to fail if the overall market goes south, leaving those investors holding billions’ worth of debt. It has been suggested that there has been movements within the markets to the lenders’ favour – in terms of more rules over ‘collateral leakage’ whereby quality assets slip out of the reach of creditors – but the fears still remain. Industry onlookers have said that ‘unjustified add-backs will be the biggest issue in this cycle… we went from ebitda, to adjusted ebitda, to further adjusted ebitda to pro-forma (ebitda)… it’s almost comical’. Furthermore the cause has been suggested to be an imbalance in the borrower’s favour, as ‘borrowers are able to exert greater influence’ due to less opportunity to make money from the lending market and, as a result, greater terminological ‘adjustments’ are allowed because investors are seeking returns. In the Reuters article in May, it discussed how ‘the market won’t just take hits on add-backs hook, line and sinker… lenders are provided with reconciliation of ebitda and adjustments. The information is there if needed’ and that, crucially, ‘credit rating agencies also provide impartial third-party analysis’. An onlooker noted how add-back-related information ‘isn’t necessarily what the company is asking us to use’, adding that rating agencies would sometimes ‘agree to disagree’ on the analysis. S&P’s report in September agrees with this view. S&P stated that its ratings are based on projection of a company’s growth and earnings, and also their own calculations of leverage ‘and not what is presented to us’. The rationale for this, according to S&P, is that ‘if we took the marketing leverage presented to us and bought into pro-forma add-backs, projected earnings, and debt reduction, our initial issuer credit ratings would likely be higher and mostly likely lowered as actual results are reported’. They continue, definitively, by declaring that ‘marketing leverage and the language around add-backs as defined by debt agreements do not determine our view of credit risk’, although they ‘often do give some credit to add-backs or synergies that we view as achievable, especially when a company has demonstrated its ability to realise on similar items in past comparable transactions’. Furthermore, S&P declare that they are ‘almost always considerably less optimistic than management when it comes to certain elements pertaining to future growth’. Ultimately, S&P state that ‘in fact, our analysis goes much deeper than EBITDA and examines the true cash flow characteristics of issuers’. So, whilst some elements of the above statements are a little subjective, S&P are clear and definitive in their pronouncement that they examine much more closely than just taking EBITDA adjustments at face value. So, why are there concerns?

The FT article from Friday starts with the example of ’24 Hour Fitness’, a California-based chain of gyms. An $850 million loan issued by the the company was recently rated single-B plus, with S&P believing that ‘any increase in the company’s leverage from leases on new gyms would be offset, eventually, by higher revenues. As a result, the company would be able to maintain a debt-to-earnings ratio of six times’. However, as the article points out, that eventuality has not come to fruition, with S&P last week cutting the debt instrument’s rating to single-B minus as the agency found that revenues generated by the chain were less than expected when the loan was issued – ‘the market price of the debt plunged to distressed levels’ as a result. The article suggests that this is a potentially systemic problem in that just 9% of new deals in 2019 carried leverage over 7 times, including add-backs. However, strip those add-backs out and that number shoots up to a massive 46%. Critics have argued that rating agencies are not keeping up with the ‘deterioration in the quality of deals’ and that, ultimately, one cannot ‘count on the rating agencies to protect you at the end of a cycle’. Yet, others have argued that the situation is much different than before the Financial Crisis, in that a. the risk of default in products are much more pronounced and therefore more well-known now and that, as the rating agencies are arguing b. a lack of protection within the debt instruments is both increasing the risk of default but also providing issuers with greater wiggle-room to avoid defaulting. After all, it is not the job of the rating agencies to define the debt practices of the marketplace, just to rate the products and those issuing them.

Ultimately, it seems that these concerns are either one of two things, or perhaps a mixture of both. There is a great deal of PTSD from the Financial Crisis and any time there is an opportunity for the agencies to transgress – as they would be here if they were to be accepting EBITDA-related adjustments without further scrutiny – the general fear is that they will do so. There is also the fear that, just like in the Crisis, a downturn could cause a chain reaction of which the rating agencies themselves would likely trigger – a few credit rating reductions and the wildfire could spread, leading to a systemic crisis. However, there are two points to raise here. First, the credit rating agencies are being scrutinised more than ever, and this EBITDA-adjustment system does not lend itself well to agency manipulation; the effects of that manipulation will be too easily discovered once the financial results are released, and they are released at too closer an interval. Second, the concern being raised against the agencies is probably misdirected. Whilst regular readers will know I have been heavily critical of the agencies, we must be fair. In this particular scenario, it is the investors who are at fault, or at least the system that is predicated upon large-scale investing. The need for returns, even in an environment that is incredibly restrictive, means that investors are taking much greater risk. Should they be allowed to do so, particularly when there is an increasing systemic risk building, is another matter – it is likely a political question and as we moved away from the Financial Crisis, right-wing governments were selected to drive the economies away from the Crisis-era; it is likely not in their remit to restrict the actions of investors on a systemic scale. But, the system needs investors to keep investing in spite of the risks, so much so that the responsibility to protect the system is placed upon institutions like credit rating agencies. In this instance, incredibly, that is likely very unfair. There is a much greater problem than the agencies at play here and, as long as the agencies do not succumb to the seduction of short-term profit (of which it would be very damaging indeed), then they will not be to blame if this particular ‘bubble’, for want of a better term, goes bang. Even the oligopolistic protection of the rating industry will not protect the agencies if they do choose to succumb, because their involvement would be so incredibly obvious. Time will tell of course, and with the Big Three we can never say never but, at the moment, these concerns are probably best aimed elsewhere.

Keywords – credit rating agencies, EBITDA, loans, LBOs, @finregmatters