The TEXPERS Blog

Private credit EBITDA add backs – what do they mean and why should investors care?

By Linda Chaffin, guest columnist

A common question among investors, credit managers and consultants is: “Where are we in the credit cycle?” While credit markets will ebb and flow, most believe we are presently at the more competitive end of the spectrum. And in a competitive market, pressure on financing structures and documentation can be expected. In my view, a key challenge is a current shift in the magnitude and type of EBITDA add backs that are being used to justify higher debt levels and valuations.

EBITDA (earnings before interest, tax, depreciation, and amortization) is a proxy for cash flow to service debt and used to value a company by applying a multiple, such as 8x EBITDA. Since this metric is a key driver for company valuation and financing capacity, it is not surprising that investment bankers and company owners seek to maximize EBITDA.

From a credit perspective, EBITDA addbacks are not a new concept. It gets tricky when borrowers propose more subjective add backs that are intended to justify debt issuance that is not prudent. 

The types of EBITDA adjustments may include:

EBITDA Adjustment Type	Description
Transaction Related	Seen in most financings, these common adjustments are for one-time deal-related costs, sponsor management fees, non-cash or non-recurring compensation and severance costs
Potential Cost Savings	Add backs for anticipated savings such as modified compensation, reduced rents and headcount reductions are more complex. To evaluate these, a quality of earnings report can be obtained to analyze the proposed adjustments. These can be allowed as an EBITDA add back with proper review and documentation
Run-Rate EBITDA	Later in a credit cycle, borrowers may propose addbacks that are extrapolations of recent performance. For example, a borrower may propose annualized credit based on a short period of recent performance (three-month EBITDA multiplied by four to calculate an annual rate). In these cases, it’s best to look to the borrower’s history of achieving projected outcomes as well as considering seasonal impacts
Maturity Credits	In certain industries, a borrower may request adjustments for future expected performance. For example, if new offices have been opened in a medical practice, the borrower may seek credit for a mature patient load. Quantifying and approving these adjustments requires significant work
Incremental Expenses	Corporate carveouts and family-owned businesses may need to build in costs for additions to staff, systems, and facilities

For any lender, getting to an accurate EBITDA amount is important for making appropriate credit decisions as well as setting financial covenants, specifically, the maximum permitted leverage ratio (funded debt / EBITDA). For lower middle-market companies, a miss of the leverage covenant is often the triggering event bringing borrowers and lenders to the table for discussion. In most cases, getting to the table earlier helps to preserve value.

Unjustified addbacks can hide the true level of leverage so astute lenders should know how to analyze and challenge EBITDA adjustments line by line to ensure they understand the borrower’s ability to service debt. To gauge portfolio risk, it is important for investors to understand a private credit manager’s philosophy around and process for evaluating EBITDA add backs.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of NXT Capital' or TEXPERS. 

About the Author:
Linda Chaffin oversees NXT Capital’s investor relations activities and fundraising efforts. She is actively involved in raising third-party funds and developing and maintaining investor relationships across the institutional LP community, including insurance companies, public and corporate pension plans, foundations, endowments and consultants. Chaffin brings more than 20 years of investor relations, fundraising, private equity, corporate finance and M&A investment banking experience to NXT. Before joining NXT Capital in 2017, she was senior vice president for Pathway Capital Management where she was responsible for raising new capital and developing and maintaining investor relationships for both private equity and private debt strategies. Prior to joining Pathway, Chaffin was vice president of Finance and Investor Relations at Marwit Capital where she led the firm’s fundraising efforts. Before joining Marwit Capital, she served as a senior vice president in GE Capital’s Beverly Hills office and held numerous roles within J.P. Morgan’s M&A, Asset-Backed Securities and Healthcare groups in New York. She began her career with various corporate finance roles at Huntington National Bank and Stern Stewart. Chaffin earned a bachelor's degree in Business Administration from The Ohio University and a master's degree in business administration from The University of Chicago Booth School of Business.