By Charlie Perer, Co-Founder and Head of Originations, SG Credit Partners
Today’s investment bankers play a very powerful role in the market and have transitioned to asking lenders to consummate financings based on adjustments to EBITDA rather than actual EBITDA, which presents real challenges for lenders across all markets. Charlie Perer, co-founder and head of originations at SG Credit Partners, compares today’s “adjusted” world to that of titular sci-fi flick “The Adjustment Bureau” as he spells out what shifting lines in the sand mean for the specialty finance industry.
“The Adjustment Bureau” is a 2011 science fiction movie starring Matt Damon. The movie is about a mysterious group called the Adjustment Bureau that is controlled by a secretive chairman who has the power to make adjustments to society as he sees fit. Flash forward to the state of today’s deal society and you can replace The Adjustment Bureau with investment bankers, who make adjustments to EBITDA as they see fit. Today’s deal environment is arguably driven by EBITDA adjustments, as it is rare for a deal to ever close on “real” or “normal” EBITDA. We live in an “adjusted” world that is controlled by sophisticated investment bankers, who rightly use the over-supply of capital to their advantage. This means any lender factoring in a leverage multiple on its own or in conjunction with a borrowing base is being pushed out of its comfort zone. The challenge for all lenders, whether ABL or cash flow, is many of the new adjustments that lenders are being asked to believe will not turn out to be real. Unlike the movie, the real-life EBITDA Adjustment Bureau (i.e., investment bankers) are simply presenting a potential case and leveraging a hyper-competitive market to get deals done.
Recent adjustments to EBITDA include, but are by no means limited to: COVID-19, supply chain disruptions, a nationwide worker-shortage, port backlog delays of inventory, pro forma margin improvement and inflation, among others. This list is not even close to completion and many disparate industries are facing different challenges where they all feel the need to portray this as temporary. Lenders, in real-time, need to make pretty significant credit decisions based on very fluid situations. The task at hand is made more complex due to the leap of faith in believing what should be adjusted versus what is a “new normal.” The “normal” is rates are rising, inflation is here, and so costs are going up – labor, raw materials and capital costs. One could argue these are not adjustments, but business conditions. Correspondingly, for many companies, EBITDA is going to decrease until – and unless – meaningful price increases can be passed on. The likelihood of price increases being pervasive across all industries is low, so we go back to the point of when is it appropriate to use adjusted versus real EBITDA.
The answer to that question depends on who you ask. Private equity and strategic buyers might not care because, to be fair, some adjustments are real and acceptable if a buyer can mitigate them. Where the adjustments become murky is in a pure debt refinancing or stand-alone acquisition scenario. These are situations where the lender has to get comfortable with the enterprise’s value based on adjustments that might not be practical and, just as importantly, adjustments that have no bearing on actual cash. The Adjustment Bureau clearly effects cash flow lenders more as it could be easy to wake up and find yourself 10 times leveraged instead of four times leveraged when the adjustments don’t play out. It does not take many of these situations for alarms to start going off inside risk departments of banks and non-banks. That said, it should also be noted this trend will also affect the ABL world.
Asset-based lending is not immune to over-relying on adjusted EBITDA, as the same issues still persist. Liquidity could easily evaporate if an ABL relies too heavily on adjusted EBITDA, which does not ultimately convert to cash. The asset-based lender will arguably be better positioned for a work-out, but it’s still a work-out nonetheless based on over-reliance on adjusted EBITDA converting to cash. Today’s middle-market ABL is edging closer to the cash flow world in terms of factoring in enterprise value and either going deeper into collateral or also providing cash flow term loans. EBITDA adjustments are heavily factored into to the underwriting process as part of traditional debt service calculations. So, why are we now dealing a very new set of adjustments that are truly untested? The simple answer is lenders have to lend and we are in a competitive market. The longer more nuanced answer is we are professionals paid to solve problems in a very aggressive market.
Adjustments are meant to tell an alternate story that will ideally become reality. Most lenders realize this and have ways to work within this new environment of adjustments. Successful lending teams are able to maintain discipline through various means including covenants, utilizing industries expertise and getting comfortable with enterprise value. Some lenders are just being prudent and basing their structures on what they deem to be real EBITDA. Others simply lack the discipline or have a more aggressive mandate. Soon enough, the market is going to see the not-so-invisible hand of the Adjustment Bureau at work when the same advisors who put these deals together are going to be paid restructuring fees to take them apart. At the end of The Adjustment Bureau, the Chairman commends Matt Damon on his devotion to reality and similarly speculates one day, the deal community will return to a world with fewer EBITDA adjustments. That day, however, is not today