Credit Due – Cash Flow or Cash Faux?

By Randy Schwimmer

Leveraged lending guidelines have set six times total leverage as the limit above which a loan would likely be criticised by examiners. Less noted by the media, but of growing interest to market players, are the components of leverage metrics: specifically, how the numerator (debt) and the denominator (earnings) are being massaged to put the best face on increasingly leveraged transactions.

The industry generally uses the term “debt-to-cash flow” to talk about leverage. What it really means – and the way the regulators define it – is debt to ebitda – that is, earnings before interest, tax, depreciation and amortisation.

Let’s look first at the debt definition: guidelines specify total debt to earnings. That includes not only the loan being syndicated, but any other corporate debt, whether bonds, subordinated debt or even a holding company instrument. Holdcos often get overlooked, but rating agencies consistently sweep any security or tranche with a coupon under the debt umbrella. That’s because parent company debt is usually serviced by opco cash flows.

Also often missed is that the calculation includes committed debt. That means not only undrawn capacity under a revolving credit facility, but any additional debt allowable under the credit agreement. Leveraged borrowers often have baskets with built-in incremental capacity. Regulators assume they are drawn on day one.

Ebitda is one of the most universal accounting concepts in corporate finance, but it is not actually defined under generally accepted accounting practices (gaap). Not being grounded in gaap means ebitda and its variants exist in a grey area when it comes to underwriting standards.

Any first-year lev fin analyst is familiar with the idea of “adjusted” ebitda. The nature of these adjustments is as varied as the types of expense incurred by private equity sponsors buying businesses. For example, if there are expected employee layoffs as part of a merger with an existing platform business, the cost of severance and transition expenses can be added back to ebitda.

Another common “add-back” is costs of the deal itself. Also typical are plant closings or sale of real estate at a loss.

Beyond expense padding, buyers scrutinise borrowers’ sales profiles. If a significant new customer contract has been signed, revenue from that may be annualised to enhance cashflow. In some industries – co-location or data centres, for example – it is accepted practice to annualise the latest quarterly revenues coming from new centres to come up with higher pro-forma ebitda.

The concept of adding back “non-recurring” expenses is standard operating procedure, but has seen envelope-pushing in this toppy market. Some “one-time” charges are fairly well-scrubbed, like the sale of a product line. More elusive are working capital items like receivable or inventory write-offs. One veteran credit pro we know dubs these “recurring non-recurring” charges.

Of course for regulated entities the game is to finesse ebitda so that total leverage comes in below the magic six-times threshold. Experienced loan buyers must be adept at figuring out which adjustments meet the sniff test and which don’t. As a gentle reminder, regulators warn they will “criticise situations in which ebitda is defined in loan documents in ways that allow enhancements to ebitda without reasonable support”.

Randy Schwimmer is senior managing director and head of origination and capital markets at Churchill Asset Management, a newly formed credit asset management firm affiliated with TIAA-CREF Asset Management. He is also founder and publisher of The Lead Left (, a weekly newsletter about trends and deals in the capital markets.

This column first appeared in the weekly newsletter of Creditflux, a leading global information source for the credit trading and investment market.

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