April 20, 2017 - Recent statistics suggest both a flattening and a substantial increase in leverage in the last quarter. While that does not seem possible, when one teases through the data, it appears that – like the famous cat – both states may exist simultaneously. We drill down below.
The issue of whether leverage has been rising materially has been perplexing us for the past week. The confusion kicked off when, in its quarterly review, S&P/LCD calculated (off 26 deals) that 3.8% of first quarter LBO loans were levered over 7x, slightly down from the 4.1% (off 74 deals) tracked in 2016. This would indicate that leverage was flattish. But then ThomsonReuters LPC reported that the share of highly leveraged deals was increasing. In fact, TR-LPC reported that one-third of buyout loans were levered over 7x; they added that 40% and 53% of LBO loans hit this leverage bogey in 2014 and 2007, respectively.
We were puzzled by the discrepancy. But new research from CovenantReview this week may have solved the riddle. The answer? It may be all about EBITDA adjustments. CovenantReview statistics show that typical EBITDA adjustments in M&A deals were around 24% in 2016. In 1Q17, based off a sample of 28 M&A transactions, the average EBITDA adjustment was 31%. Narrowing it down to their 22 sponsored M&A deals, EBITDA adjustments were 34%.
The larger EBITDA adjustments mean that the gap between reported leverage and adjusted leverage would widen as well. The nearby chart shows the average total leverage (based on adjusted EBITDA) on sponsored M&A loans remained basically flat at 5.37x in first quarter. However, total leverage based on reported EBITDA (excluding any adjustments) climbed a quarter turn to 7.38x. Thus, TR-LPC’s number (one-third of LBO loans leveraged over 7x) and S&P/LCD’s number (4% of LBO loans leveraged over 7x) could exist simultaneously.
But which are the “right” leverage numbers? Again, the answer may be an unsatisfying “both”. The reported leverage show the level on a look-back basis, which is of course very valuable. But buyers buy companies to improve them. They often have specific and tangible plans to improve EBITDA, such as closing a money-losing line or factory. EBITDA adjustments such as these are very legitimate, so they shouldn’t automatically be tossed out. At the end of the day, both sets of numbers provide insight. This cat’s state remains ambiguous.