If accounting gods and powerful lenders had any mercy, they would give finance teams free rein to add back to profits all kinds of COVID-19 expenses. For example, the cost of paying idled employees or the rent and utility bills on facilities idled during lockdowns. Or the tens of other “abnormal” line items that gouged earnings in 2020 and 2021.
Unfortunately, the SEC’s division of corporate finance’s disclosure guidance on COVID-19 does not have such a liberal view of adjustments. The guidance cites the two costs above, in particular, as being impermissible “add-backs.” Any competent lender or potential investor in your company is likely to also be suspicious of, for analysis, pretending those costs didn’t happen.
These expense adjustments — or add-backs — boost the profit numbers through adjusted EBITDA. And they reduce the amount of recurring expenses. Adjusted EBITDA is a key measure used in financing deals and business valuations. It helps figure out a borrower’s capacity for incremental debt and dividends, for example.
Potential COVID-19 Add-Backs
Why should CFOs care? No self-respecting finance executive wants to be fooled by another management team’s too-rosy earnings forecast. If your company or sponsor is a strategic buyer or, say, an investor in a startup, you need to cast a skeptical eye on add-backs. Rejecting add-backs that don’t make sense gives a clearer view of the target’s risk profile, leverage ratio, and earnings potential.
If your company is a borrower or a seller presenting an adjusted EBITDA number in hopes of getting a higher bid, you need to know which add-backs will get the thumbs-up and which will be rejected. Advisers to small business owners and middle-market companies often recommend maximum aggressiveness in add-back inclusion. But doing so can strain the relationship with a buyer or lender.
Besides a hot M&A market, there are three reasons CFOs may run into add-backs this year, and why they need to be wary.
One, the financial markets have accepted increasingly aggressive methods of calculating adjusted EBITDA. That results in lower leverage ratios, according to Proskauer. EBITDA add-backs were sometimes capped as a percentage of EBITDA (15%-25%), but the caps are disappearing in many transactions. In the middle and upper-middle markets, caps never existed.
Two, COVID-19-related adjustments will be relevant in the capital markets for a while, as companies disclose historical financials. Financial covenants, for example, are often tested on a last-12-months basis.
Three, a recent study by Standard & Poor’s of large M&A deals and leveraged buyout transactions involving speculative-grade issuers made an interesting discovery: “EBITDA add-backs at deal inception continue to be substantial and overstated, resulting in understated leverage and purchase price multiples.”
So, the adjusted EBITDA number in deal marketing materials is an unreliable indicator of future earnings, according to S&P. The issuers studied couldn’t achieve the earnings, debt, and leverage projections they told investors or lenders they would.
“Deal arrangers, sponsors, and management teams continue to raise the aspirational bar in selling what qualifies as an add back,” opines S&P. The credit rating agency said it views the “ever-expanding” definition of management-adjusted EBITDA as an artificial deflation of leverage and an inflation of profitability that contributes to understated valuation multiples.
That seems on the mark. After all, as S&P found, forecast synergies and cost savings in M&A and LBO deals tend to be the most significant components of add-backs, up to 30% of the total. And we all know how shaky those projections are.
“Deal arrangers, sponsors, and management teams continue to raise the aspirational bar in selling what qualifies as an add back." — Standard & Poor's
From the glass-half-full view, there are plenty of allowed add-backs. The SEC and FASB list three types of expenses: “extraordinary,” “non-recurring,” or “unusual.” SEC guidance on COVID-19, for example, says the purchase of personal protective gear, including face masks and hand sanitizer, the cost of cleaning and disinfecting facilities more frequently or more thoroughly, and the IT and training costs associated with transitioning to remote employees can all be added back to EBITDA.
According to the SEC’s division of finance, “estimates of lost revenue are a non-GAAP measure that should not be included to normalize the results of operations in SEC filings.” Accordingly, Proskauer advises lenders and investors not to allow this adjustment either.
For those interested in an accurate picture of how companies are performing financially, the scariest thing about add-backs might be this: according to Fitch Ratings, they have dampened the negative impact of the pandemic on the results of some issuers.