More than just EBITDA-T - Urbaser's Attempt to Add-Back Tariffs

More than just EBITDA-T

The market was buzzing this week over Urbaser’s inclusion of tariffs in their litany of add-backs to EBITDA, but the reality was actually worse than that for lenders. The provision was ultimately removed from the terms of the borrower’s debt, but its inclusion portends of future borrower flexibility – and wise lenders will prepare.

What was different about this EBITDA add-back?

It has long been the case that EBITDA add-backs proliferate with bull markets. The concept was originally used to adjust a company’s earnings to reflect a “normalized” or more representative level of profitability, especially in the context of mergers, acquisitions, and leveraged buyouts.

Traditionally, these add-backs included clear, justifiable items such as non-recurring expenses, owner compensation above market rates, and extraordinary legal or transaction costs.

Over the past decade, the use and scope of EBITDA add-backs have expanded significantly:

Magnitude Increase: The average total add-backs as a percentage of reported last-12-months EBITDA at deal inception has grown dramatically, reaching as high as 53% in large M&A and LBO transactions between 2015 and 2022 according to a study by S&P Global. The study noted that in deals originated in 2022, add-backs represented over 29% of management projected EBITDA and almost 55% of LTM reported EBITDA.

Optimistic Adjustments: Companies, especially in highly leveraged transactions, have increasingly used aggressive and sometimes aspirational add-backs. These can include projected cost savings, synergies, and even adjustments for anticipated – but not yet realized – business changes.

COVID-19 Impact: The pandemic introduced a new wave of add-backs, with companies adjusting EBITDA for COVID-related costs and lost revenues, further expanding the types and frequency of adjustments.

Lender Response: This increase in the quantum of add-backs resulted in lenders insisting that add-backs derived from certain components used to enhance to covenant calculations be limited from 10-25% of EBITDA – but these caps do not appear in every deal.

The Trend Reveals What’s Next

Given the response of borrowers to COVID-19 – including add-backs in response to market events – it is no surprise that we’ve seen a tariff-related add-back appear in a deal. This won’t be the last time, and as such we felt at Fox Legal Training that it would be important to analyze this instance so lenders know where to look should this add-back appear again.

More Than an EBITDA Add-Back

Due to the location of this add-back language, the provision would have applied to allow more than just add-backs to EBITDA. It appeared in the borrower’s Financial Calculations covenant, which applies to all calculations across the covenant package.

As we teach in our Leveraged Finance Covenant Training course, the Financial Calculations covenant is a modern invention designed to pull together all relevant calculation-related provisions into one place.

At first glance, this seems like a great idea, and there are benefits. We teach our clients that any attempt to calculate covenant capacity must begin here, as the terms apply so broadly. Here you will find provisions about when calculations can take place, how to calculate the numbers, and – apropos to this question – what can be added back.

And not just to EBITDA – the provisions in this covenant apply to all calculations. As a result, should the provision have gone through in Urbaser’s deal, and if it appears again in a similar way in a future deal, not only will tariffs be permitted to be added back to EBITDA, but they will also be added back to Consolidated Net Income as well.

Why Consolidated Net Income Matters

Consolidated Net Income is only used as a base calculation for EBITDA – making it a critical aspect of any covenant analysis, but it is also used as the basis for Restricted Payments capacity in the builder basket.

The builder basket is a cumulative measure of capacity for borrowers to pay dividends, repurchase capital stock, repay subordinated debt, and invest in entities that are outside of the restricted group. It becomes, over time, the most significant source of capacity for borrowers to make these types of payments.

We could write an entire article on the enhancements to the builder basket that have appeared over time – but that is outside of the remit of this article.

History on Repeat

The upshot for lenders following Urbaser’s inclusion of tariffs as an add-back in the Financial Calculations covenant is the continued departure of borrower terms from reality. We will follow this article with another covering all of the ways in which this is happening, as it has been developing over the course of years rather than months.

For now, we urge lenders to always review the Financial Calculations covenant first when attempting to estimate covenant capacity (and yes, it will always be an estimation – as only the borrower has all of the information to come close to an accurate calculation of the figure). If history has taught us anything in the world of leveraged finance covenants, it’s that it loves to repeat.

To find out more about Fox Legal Training’s online, on-demand legal training enablement offering, contact us at info@foxlegaltraining.com or visit www.foxlegaltraining.com.

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