The Great EBITDA Illusion
Why Management Projections Miss by a Mile and Investment Implications
I enjoyed this quote:
“failure to provide potential bidders with a clearly defined, well-substantiated case for pro forma EBITDA adjustments as part of the divestiture strategy is truly to leave money on the table.”
Where did it come from? Was it:
A private equity firm’s internal manual on writing sales memoranda?
A letter from an activist investor to a company board?
An S&P 500 M&A department’s operating procedure?
A sales document from a big 4 accounting firm?
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In truth, it could be any of those four, although it was in fact number 4. Now we all remember Charlie Munger’s description of EBITDA as “bullsh*t earnings” and the scepticism with which Mr Buffett addressed the parameter on various occasions, including a withering analysis of its use in the telecoms sector.
Mr Buffett of course deeply understands that depreciation is a real cost. If anything, depreciation understates the true cost, as you generally pay for capital equipment upfront. Therefore, the annual depreciation is lower than the actual, present value, impact; and even more so in a period of inflation, as to replace the asset will usually cost more than the total depreciation.
The quote comes from a study by KPMG on the use of adjusted EBITDA in M&A transactions, sub-titled, “The net result: greater rigor in the M&A process”. I know…….
KPMG examined 1800 transactions between 2013 and 2018 and found that both the number of adjustments to EBITDA increased, as did the value. The number increased from 5.8 to 7.9 per transaction and the value increased as shown in the chart:
Average Adjustments Value in M&A Transactions by Year
Source: KMPG
KPMG noted the increase in housekeeping adjustments (eg accounting policy changes) and in non-cash adjustments (from 4% to 8% of reported EBITDA) which included non-cash stock compensation.
“Transaction related expenses such as professional fees are not viewed as recurring operational costs or as part of operational cash flow”. For an average p-e fund, these are quite regular in nature, I would suspect.
Pro-forma adjustments have risen by 10% and were in over 60% of deals. These include cost-related adjustments, to reflect the future value of cost reductions, and revenue run-rate adjustments, including planned price increases, or the expected impact of a new product line. In my experience, cost savings tend to have a higher deliverability as they are more within management’s control; but it’s a rare business which can increase price without affecting volumes, while capacity increases are often tricky to model.
Perhaps needless to say, KPMG advises using their Transaction Services Team to help buyers and sellers with transactions, although they don’t seem to have issued a follow up report, in spite of their promise “to continue to track and analyze the growing use and impact of seller adjustments in due diligence”.
S&P’s Leveraged Finance group have also looked at the topic of EBITDA adjustments, but through a different lens.
“Our six-year study on EBITDA addbacks appears to shows a positive correlation between the magnitude of addbacks at deal inception and the severity of management projection misses.”
They highlight that addbacks represent a median 30% of management adjusted EBITDA at deal inception. They consider management projections to be aggressive and U.S. speculative-grade corporate issuers generally
“present earnings, debt, and leverage projections in their marketing materials at deal inception that they cannot realize”.
In year 1, 95% of companies miss projections and in year 2 this improves to 84%. Almost 1 in 6 companies beat in the second year. But 5 in 6 do not and the degree of miss is significant, with the average miss being around one-third of projections. The chart shows the degree by rating category, but I find this hard to read:
Year 1 Reported vs Projected EBITDA
Source: S&P Global
I recently did a seminar for the CFA Society in the UK on how to draw charts and how not to – it amazes me that so many analysts have so little clue as to how to analyse and present data. We have ever increasing quantities of the stuff, so surely this is important. The presentation went down well and I am happy to deliver it (for free!!!) to similar bodies or universities – fill out the form on the website.
The misses on leverage are even scarier, on average 3.6x (median just 2.3x, suggesting that the bigger companies are worse):
Year 1 Reported vs Projected Leverage
Source: S&P Global
The main categories of adjustment to reported EBITDA are shown in the chart:
Types of Adjustments to EBITDA
Source: S&P Global
And here is the trend over time, including the averages, which illustrates that the proportion varies each year, within an overall rising trend:
Adjustments by Type (% of Total)
Source: S&P Global
S&P disclose that EBITDA addbacks remain elevated, with addbacks for deals originated in 2022 representing over 29% of management projected EBITDA, and almost 55% of last-12-month reported EBITDA in their latest sample of large mergers and acquisitions (M&A) and leveraged buyout (LBO) transactions. The chart illustrates that the trend has been upward:
Addbacks are Trending Up
Source: S&P Global
Their universe of 604 transactions is split:
M&A 56%/ LBOs 44%
B rated 87%/BB 13%
Sponsored 76%/not sponsored 24%
So it’s not all private equity.
The chart below shows the level of addback by sector, with high tech being the most popular transaction and the one with the highest level of addback. This could be a function of high levels of stock-based comp with health care also having a high frequency and similar levels of addbacks.
Resources are at the other end of the scale which is reassuring and in line with what I would expect, although a 20-25% increase in profitability is still significant.
Addbacks by Sector
Source: S&P Global
And here is their analysis of the addback types by sector (another hard to read chart):
Addbacks by Sector
Source: S&P Global
S&P concludes:
“Our six-year study on EBITDA addbacks appears to shows a positive correlation between the magnitude of addbacks at deal inception and the severity of management projection misses.”
Surprise!
And this is of real significance, especially to lenders. The chart below drills down into the S&P data and summarises the difference between leverage as projected by the borrower and the actual out-turns in years 1 and 2.
Forecasts made in M&A deals turn out badly with leverage nearly twice the projection in year 1 and worse by end year 2. Most of the miss is down to over-estimating adjusted EBITDA. The median miss in year one was 34%, rising to 35% in year two.
Leverage Forecasts are Understated
Source: S&P Global
Leverage forecasts made in leveraged buyout transactions are much worse with actual leverage of 8.2x vs a 3.9x forecast. This is for sponsored deals made in 2015-2020, so there is a Covid effect, as you can see in the chart below, plotting the outcomes by deal year:
Average Leverage Under-Estimate
Source: S&P Global
Covid obviously had a deleterious impact, but the result pre-Covid is still shockingly bad. I calculated the averages for the whole time series and for the series excluding Covid-affected outcomes and this is shown in the chart below:
Leverage Estimate Accuracy with and without Covid
Source: Behind the Balance Sheet from S&P Global data
There is a separate data set for deals with no sponsor and the results are worse for deals with a sponsor than for deals without a sponsor:
Average miss year 1 and year 2 with a sponsor: 4.1x and 4.3x
Average miss year 1 and year 2 with no sponsor: 2.4x and 2.7x
This is a pretty significant difference – it would appear that you are more likely to lose money dealing with a big private equity firm which is proposing a transaction as they are more likely to be aggressive with projections.
Conclusions
The S&P report concludes:
“Our six-year study continues to underscore that addbacks and company-adjusted EBITDA are a poor predictor of profitability. Our substantial dataset makes it clear that management teams and equity sponsors regularly miss their projections by a large margin, and that the magnitude of the misses is positively correlated with addbacks and firms that we rate lower. This suggests that inflated addbacks may help companies with higher financial risk get deals done.”
The data is clear and there is no reason to doubt it. What surprises me is that private equity and credit funds continue to engage in such practices and that allocators and credit investors appear relaxed. That may be justified given past performance, but as I have written here several times, I don’t believe that the historical record is anywhere near sustainable. When investors start losing money, the perception will presumably change.