Since the Federal Reserve issued guidance on leveraged lending limits in 2013, borrowers and lenders have been keenly interested in the ratio of debt-to-EBITDA in proposed financing packages. Under the Fed guidance, banks are supposed to steer clear of deals for which the ratio is 6.0x or greater. An article in last week’s Wall Street Journal highlighted the use of earnings adjustments to help pull down the magic leverage number to an acceptable level.
Case in point: In August, William Morris Endeavor acquired UFC (Ultimate Fighting Championship) for an aggregate purchase price of $4.0 billion. The purchase was reportedly financed with $1.8 billion of debt. With reported EBITDA of $170 million, the resulting debt-to-EBITDA ratio of 10.6x would have run afoul of the leveraged lending limits. However, for purposes of underwriting the loan package, the reported EBITDA was adjusted upward to $300 million. The higher denominator pulled the leverage ratio down to 6.0x, the edge of the acceptable range under the Fed guidance.
As noted in the article, such adjustments can be necessary; we have no opinion as to whether the adjustments in question were appropriate. We are certainly not looking to get in the octagon over this.
The article did, however, bring the topic of earnings adjustments to the fore. Valuation professionals commonly employ earnings adjustments, whether measuring the fair value of a portfolio investment or a reporting unit, or developing market participant prospective financial information (PFI) for a purchase price allocation. Earnings adjustments are an important part of a valuation professional’s bag of tricks, but they are susceptible to misuse. The purpose of earnings adjustments is to convert the income statement from one that is backward-looking to one that is forward-looking. In the remainder of this post, we review some characteristics of legitimate (and questionable) earnings adjustments.
- Clean up unusual or non-recurring events. The most obvious earnings adjustments are those that remove the effect of unusual or non-recurring events that have occurred in historical periods. Events such as losses due to unusual weather events, large recoveries in litigation, or transaction costs incurred to close a major acquisition may distort the historical earnings of a company, obscuring the true ongoing earning potential of the business. One must be cautious, however, against the tendency to label every roadbump that the company has encountered over its history as “non-recurring” while assuming that every bit of good fortune has been representative of ongoing earnings. A series of annual, non-recurring losses begins to look like a recurring feature of the business. The goal is to normalize earnings, not to sanitize them.
- Remove the effect of discontinued lines of business. Business lines come, and business lines go. To get a clean view of the future prospects of the business, the impact of business lines that are no longer active needs to be excised from the historical financials. If the discontinued business was profitable, removal will reduce historical earnings, and vice versa. While sales and cost of sales can generally be readily identified, associated operating expenses may be more difficult to estimate. If too much of the expense base is allocated to the discontinued business, the adjusted historical earnings will be overstated.
- Add the impact of recently acquired businesses. For acquisitions that are made during the most recent fiscal year, the historical earnings of the acquirer will not reflect the full impact of the acquisition on ongoing operations. For example, if the legacy business generates annual EBITDA of $10 million, and the new business acquired at the midpoint of the year creates annual EBITDA of $5 million, the combined business during the year of acquisition will have reported EBITDA of $12.5 million. This historical figure would need to be adjusted to $15 million to capture the true “run rate” of the business. For acquisitive businesses, these adjustments can be significant. While appropriate, the risk with these adjustments is that the actual earnings of the acquired company fail to reach the level assumed in the “run rate” analysis. Care should also be taken to ensure that additional corporate overhead to be incurred in conjunction with the acquisition is reflected in the adjusted earnings figure.
- Eliminate the impact of non-cash earnings charges. Some earnings measures, like EBITDA, already exclude the impact of what are often the largest non-cash charges, depreciation and amortization. In the WSJ article noted above, the earnings adjustments in the UFC transaction included stock-based compensation. This is an example of how earnings adjustments must be appropriate to the purpose of the exercise. From a lender’s perspective, stock-based compensation does not reduce the cash flow available for debt service, since the recipients of the stock-based compensation are accepting a future claim on the assets of the business that is junior to that of the lenders. However, from the perspective of an equity holder, stock-based compensation is a very real expense, even if there is no immediate cash flow impact. Despite the inherent imprecision of the measurement, compensating employees is an operating expense of the business, and its removal may overstate the business’s earning potential.
- Adjust for revenue synergies and cost savings. If the purpose of the analysis is to forecast cash flows to a potential acquirer of the business, it may be appropriate to identify and estimate revenue synergies and cost savings that would be expected to accrue to the acquirer. From a seller’s perspective, the question accompanying such adjustments is how much credit the buyer will be inclined to give the seller for the incremental cash flows for which the buyer is at least partially responsible. From the perspective of a lender contemplating the ability of a company expected to remain under current stewardship to service debt obligations, making such adjustments would be out of place. Likewise, for a minority equity investor that has no ability to influence or control the current stewardship of the company or to prompt a sale, such adjustments would likely be unwarranted.
Earnings adjustments are a necessary component of many fair value measurements, but must be carefully scrutinized to ensure that they do not distort the true earning capacity of the business and are appropriate for the relevant group of market participants.
- Non-GAAP Measures: The SEC Updates Interpretation of Disclosure Regulations
- Non-GAAP Measures: Here to Stay?
- Equity-Based Compensation: Are Non-GAAP Earnings Misleading?
- Leverage Lending, Dividend Recaps, and Solvency Opinions