LONDON (LPC) - Investors are concerned that adjustments to earnings made during the Covid-19 pandemic are becoming too aggressive as borrowers keep earnings artificially high to avoid covenant defaults and delay the onset of restructurings.
Borrowers are adjusting earnings as if the crisis had never happened, known as earnings before interest, tax, depreciation, amortisation and coronavirus (Ebitdac), or “earnings before coronavirus.”
“Companies may be keeping earnings artificially high in order to avoid a financial covenant breach. It could delay a restructuring that perhaps should be happening earlier,” said Jane Gray, head of European research at Covenant Review.
Ebitda is a key measure of performance and business valuation. Loosening documentation over the past few years has gifted borrowers a great level of flexibility to adjust their earnings via numerous exclusions and add-backs. It has become common practice to estimate generous cost savings and synergies on buyouts to lower leverage and make deals acceptable to regulators and investors.
However, a growing number of lawyers and investors argue that adding back coronavirus-related costs is controversial and not appropriate due to the unprecedented nature of the crisis.
“The language in documentation allows such flexibility and borrowers are interpreting it in a way that is favourable for them. But is it a correct interpretation? It is controversial,” a leveraged loan lawyer said.
German beauty retailer Douglas, which has 2,400 stores across Europe, is one such company to make coronavirus adjustments.
Last month, the leveraged loan borrower added €15m back to earnings for its second quarter results ended 31 March, to take account of what it termed, “staff and rent related idle costs in connection with our closed stores.”
Douglas’ reported Ebitda was a €1m loss in the second quarter, compared with adjusted Ebitdac of a €23m profit.
The €15m add-back also pushed leverage down by around 0.3 times, according to fintech data provider 9fin.
Changing the numbers to take account of coronavirus is seen as controversial as no one knows how long the pandemic it will last and how it will play out.
“When it comes to coronavirus, it’s a different scenario. Companies are estimating based on a hypothetical situation, and no one knows how it will turn out,” said Sabrina Fox, executive adviser at European Leveraged Finance Association (ELFA).
“Ebitdac is just a fairy tale and using it in covenant calculations would be like living in a world of imagination.”
In addition, the ELFA — whose members include Allianz Global Investors and Janus Henderson Investors — urged loan borrowers and high-yield issuers not to use Ebitdac as a calculation metric to incur additional debt.
“We discourage companies from stripping off the effects of the pandemic only to wind up with more leverage,” said Fox.
“It is by no means guaranteed that Ebitdac reflects forward-looking operating trends, and as such it should not be relied on as a calculation metric for any purpose under debt documents.”
Apart from earnings adjustments, some borrowers have taken another approach to covenant calculations by using 2019 historical figures, instead of 2020 figures in a bid to avoid breaches.
US ticket and concert company Live Nation made amendments in April with existing lenders that allowed the firm to use 2019 earnings to calculate the consolidated net leverage ratio covenant for the fourth quarter of 2020 through to the second quarter of 2021, according to the firm’s result announcement.
US luggage maker Samsonite also amended loan terms so that it could use 2019 Ebitda figures in covenant calculations from the end of September 2021 until end of March 2022.
“It’s really the same thing,” said Gray at Covenant Review. “Using last year’s figures is simply a way of justifying the quantification of the adjustment they are making. They are seeking to ‘normalise’ Ebitda as if Covid had not happened.”
The key reason for existing lenders or institutional investors to support those amendments is to limit the amount of defaulted loans in their portfolio, taking a view that the pandemic will be a short-term matter, bankers and investors said.
“It’s a sticking plaster solution,” a loan banker said.
However, no-one knows how long such flexibility could last and when lenders’ patience will dry up.
“I don’t think anyone has a clue on any of it. It’s all being done under the illusion that the world will return to normal in a couple months. By now that should be an obvious lie.” said an investor in the US. “Somebody is wrong.”
Additional reporting by Aaron Weinman; Editing by Claire Ruckin and Christopher Mangham