It ain’t what you don’t know that’s the problem, it’s what you think you know, but just ain’t so….Mark Twain

Even before the economic crisis caused by COVID-19, lenders were wrestling with the ongoing requests from borrowers for adjustments to EBITDA for purposes of financial covenants in credit agreements.  The market had clearly accepted some level of speculative addbacks that distorted the actual performance of a business and then going forward enabled a borrower to incur additional debt and take other actions based on the inflated EBITDA, where it was intended to be used for purposes of limiting transactions permitted under the negative covenants in the credit agreement.

Federal regulators noted the loosening of covenants.  Even back with the 2017 report from the Shared National Credit Program conducted by the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency, such agencies expressly warned of weaknesses in underwriting standards, including “ineffective covenants.”

Moody’s publishes a “Covenant Quality Indicator” (or “CQI”), which measures how covenants protect lenders on a scale of 1 to 5 (with a “1” being the most protective of lenders and a “5” being the least protective of lenders).  The Covenant Quality Indicator always seems to be above a “4”.

Covenant Review launched a new product in 2019 to provide “Documentation Scores and Subscores” that reviewed credit agreements in the institutional loan market to evaluate the document’s efficacy in limiting collateral leakage and limiting the borrower’s ability to put further stress on the balance sheet.  The scale runs from 1 (strongest) to 5 (weakest) and has appeared consistently to be above a “3”.

The effects of the pandemic on businesses has provided another source of challenge for lenders in understanding the actual circumstances of their borrowers as reflected in EBITDA. The issue is whether lost earnings due to the economic crisis resulting from COVID-19 may be added back to EBITDA—to create what has been referred to as “EBITDAC.”  

Industry groups like The Credit Roundtable and the European Leveraged Finance Association that are on the front lines of identifying issues for lenders and other debt investors, as well as commentators like Covenant Review, Standard and Poor’s, Moody’s and Fitch, have all noted the issue and the risks for lenders in proposals being made by sponsors and other borrowers to expand addbacks to EBITDA based on the effect of COVID-19. 

In a letter to regulators and other associations, The Credit Roundtable, a group of large institutional fixed- income managers that advocates for creditor rights and works to improve ineffective covenants and the underwriting and distribution of corporate debt, said:

Recently, certain industry groups and regulators have highlighted modifications to traditional EBITDA calculations that allow management to add back losses relating to the economic disruption caused by the COVID-19 government-enforced lockdowns.  This has become known as “EBITDAC” with the “C” representing the financial consequences of the coronavirus pandemic.  We believe EBITDAC calculations include many hypothetical, highly subjective and potentially misleading adjustments.

The Credit Roundtable and others have urged the market to resist such proposals so as to protect the position of lenders. 

While the additional addbacks do not seem to have hit the asset-based lending market in the same way that it may have the worlds of leveraged loans and investment grade lending, it is a point for asset-based lenders to watch for, as sponsors draw on practices from other markets for application to asset-based facilities. 

For a more detailed analysis of the topic, please see here the article from Covenant Review, “Will EBITDA Become Infected by Coronavirus Addback?”

For articles on this issue in Europe, please see these articles: Could Virulent EBITDA Addbacks Inflate Capacity Under European Loans and Bonds As a Result of the Coronavirus Pandemic? and European High Yield May 2020 Wrap-Up: "EBITDAC" Emerges In Europe and May Infect the Market with a New Strain of EBITDA Addback