Earnings Before Income Tax, Depreciation, Amortization, and Coronavirus
With signs that the COVID-19 pandemic may be in the rear-view, private equity sponsors and lenders have shifted focus to underwriting new transactions. The 4Q of 2020 was one of the busiest on record for new sponsor acquisitions, but many of the sponsor acquisitions involved companies that were not materially negatively impacted by COVID-19. The question of COVID-19 adjustments to underwriteable EBITDA was less critical. Now that many of the new acquisitions involve targets that were significantly impaired by COVID-19, adjustments to financial performance in new loans have become more important.
Determining the appropriate EBITDA from which to establish leveragability is a central element of any new financing. Over the years, the market had adopted standard addbacks and adjustments that were generally acknowledged as reasonable by borrowers and lenders alike. A market-standard methodology for determining adjusted LTM EBITDA in periods impacted by COVID-19 has not been fully established, however, because the middle-market lending universe has not been tested at scale by businesses that were negatively affected by the pandemic.
With no market standard and little precedent for COVID addbacks, borrowers and lenders are left largely to their own devices to determine what seems reasonable. Over time, precedent will be developed (and the COVID impacted periods will begin to roll out of LTM EBITDA). In the meantime, private equity sponsors are best served by being as proactive as possible to determine what addbacks will be acceptable to lenders to ensure that the leverage assumed in returns models is achievable before committing to the valuation in a sell-side process.
The concept of EBITDA-C (Earnings Before Income Tax, Depreciation, Amortization, and Coronavirus) is becoming more common in new deals. From both a lending and M&A valuation perspective, EBITDA-C should provide a meaningful picture of the business’ risk profile and cash flow generation while normalizing for the pandemic’s effects. Apart from avoiding covenant breaches and default on an existing credit agreement, evaluation of EBITDA-C also has important implications on new debt financings.
Most loan agreements permit various ad-backs to EBITDA for extraordinary, non-recurring, and unusual costs, expenses and losses. However, these terms are not explicitly defined and open to interpretation based on GAAP principles and commonly accepted definitions of these terms. Commonly, a credit agreement will limit addbacks to EBITDA across various categories, often capping or limiting certain categories to a certain dollar threshold. While EBITDA-C is not a GAAP term, we are seeing coronavirus adjustments to EBITDA in loan documentation to specifically carve out COVID-19-related costs for underwriting and covenant purposes. Examples of expenses and losses borrowers may seek to add back include:
- Purchase of personal protective gear (so long as it’s not usually required in the course of business, such as in the case of food establishments and hospitals)
- Costs to set up or facilitate remote work for employees due to stay-at-home orders, including IT and training, home office equipment, etc., and subsequently transitioning them back to the office
- Termination fees and other expenses incurred relating to cancelled events and contracts
- Pandemic planning expenses
- Production delays due to supply chain disruption
- Increased security and screening
- Costs associated with cleaning and disinfecting facilities more frequently or more thoroughly, as required by local and state orders
- Employee costs including temporary hazard pay to compensate employees for performing their normal duties at increased personal risk and additional time off for sickness or carer leave
- Professional fees relating to compliance with COVID-19 local and state orders and advice regarding CARES Act loans
Addbacks of Lost Revenue
Most businesses impacted by COVID-19 would argue that the key impact on their financial performance has been lost revenue. However, revenue addbacks are generally harder to justify and are typically not allowed in most credit agreements. The concept of “lost revenue” does not exist in GAAP, and has historically not been a permissible addback in the case of revenue lost due to terrorist attacks, natural disasters, etc. It is also often very difficult to quantify lost revenue.
In the underwriting of new loans, lenders are carefully evaluating revenue adjustments to the LTM period, and rightfully so. That said, many lenders understand the necessity of evaluating each transaction on a case-by-case basis, and lenders are considering various approaches to normalizing revenue.
For example, businesses with contracted revenues have been able to identify discrete loss of revenue as compared to the contractual levels, and lenders have been willing to allow for normalization to contracted levels. Companies without contracted revenue have been able to “substitute in” 2019 months into 2020 actuals to provide a normalized view of performance. This method has been most accepted for companies that have demonstrated a sharp rebound in financial performance, as lenders can get comfortable that performance has not permanently deteriorated.
In both instances, comparing the normalized financial performance to rolling annualized periods has helped lenders evaluate the “new normal,” determining whether the effects of COVID-19 are temporary or ongoing and whether financial recovery is still underway. Analysis of LTM revenue against annualized post-COVID periods (e.g., last one month annualized, two, three, four, five, and six months annualized, etc.) may show a trend of more recent annualized periods continuing to trend upwards, suggesting continued financial recovery. Alternatively, if the annualized post-COVID periods plateau, it is reasonable to conclude that the underlying company has largely recovered to its post-COVID levels. A further comparison against the normalized LTM periods can inform as to the reasonableness of the adjustment methodology.
Lenders have also sought to round out their underwriting with additional KPIs and operating metrics. For example, have sales metrics (calls, meetings, orders, etc.) recovered, and what are the trends? Has operating efficiency normalized to pre-COVID levels? These non-financial (or pre-financial) KPIs and leading indicators have been important to lenders in certain instances.
Lenders are also paying close attention to indebtedness arising from COVID-19, including severance, extended payables, deferred payments, and Paycheck Protection Program (PPP) funding that may require repayment.
The Last Page May Never be Written
The post-COVID-19 capital markets landscape is still being shaped. Over the next several months, some level of “market standard” will be developed as it relates to COVID-19 addbacks. At the same time, the periods most impacted by COVID-19 will begin to roll off the LTM period, and the question of adjustments will become less critical for many borrowers. In the meantime, sponsors evaluating new acquisitions should be carefully reviewing underwriteable EBITDA in each new opportunity to inform assumptions of leverage in their internal returns analysis.
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