The Impact of Covid-19 on Adjusted EBITDA
/As Covid-19 sends shockwaves through the global economy, this two part post identifies certain Covid-19 addbacks to EBITDA that borrowers and lenders are likely to see included in compliance certificates in this changing economic climate.
EBITDA in Credit Agreements
Adjusted EBITDA, the standard metric for evaluating a borrower’s profitability in leveraged financing transactions, has significantly expanded in scope over the last five to ten years. The market has accepted increasingly aggressive methods of calculating adjusted EBITDA, which has the effect of producing lower leverage ratios.
Given that lost revenues associated with Covid-19 are expected to be significant for many businesses (and are likely to trump related costs and expenses by measures), borrowers are searching for innovative ways to counteract revenue declines in their financials for the upcoming quarters in order to avoid covenant breaches and tightened restrictions under credit agreements. Lenders are seeing addbacks related to Covid-19 in compliance certificates, even if Covid-19 specific addbacks are not a component of the adjusted EBITDA definition.
Selected Addbacks to EBITDA
We anticipate that the boundaries of the following addbacks will be tested in upcoming financial quarters.
Extraordinary, non-recurring and unusual costs, expenses and losses
Credit agreements typically permit an addback to adjusted EBITDA for extraordinary, non-recurring and unusual costs, expenses and losses. This addback is frequently uncapped in middle market and upper middle market transactions. These terms are not expressly defined in credit agreements, but should be interpreted in light of corresponding GAAP principles and the commonly understood accounting meanings of such terms.
Extraordinary: under the historical GAAP definition, an underlying event or transaction had to be (i) of an unusual nature (defined below) and (ii) infrequent (i.e. of a type that would not reasonably be expected to recur in the foreseeable future, taking into account the environment in which the entity operates).
Non-recurring: “non-recurring” is also a non-GAAP measure and is understood to include only those items which can be described as “non-recurring” if they have not occurred within the most recent two years and are not expected to recur within the following two years.
Unusual: under GAAP guidance, “unusual” describes an underlying event or transaction that possesses a high degree of abnormality and is of a type clearly unrelated to, or only incidentally related to, the ordinary and typical activities of the entity, taking into account the environment in which the entity operates.
A borrower may also employ a less technical, colloquial interpretation of these terms, which will blur the lines of what constitutes an acceptable use of this addback. Examples of Covid-19 related costs, expenses and losses that lenders may see in upcoming compliance certificates include the following:
Purchase of personal protective gear, including face masks and hand sanitizer
Cleaning and disinfecting facilities more frequently or more thoroughly
Costs of relocating employees or equipment to areas unaffected by stay at home orders
Pandemic planning expenses
Increased security and screening for visitors and guests
Cancellation of events
Production delays and missed deadlines due to supply chain interruption
IT and training costs associated with transitioning to remote employees
Temporarily paying a premium to compensate employees for performing their normal duties at increased personal risk (e.g., hazard pay)
Terminating contracts or complying with contractual provisions invoked directly due to the events of the pandemic (e.g., contract termination fees or penalties)
Guidance on the topic coming out of the United States suggests that Covid-19-specific costs and expenses that are not (1) incremental to, and (2) separable from normal operations of a business are impermissible addbacks. Examples of impermissible addbacks might include:
Paying idled employees
Rent and other recurring expenses (e.g., security, utilities, insurance, maintenance) related to temporarily idled facilities
Excess capacity costs expensed in the period due to lower production
Paying employees for increased hours required to perform their normal duties
Paying more for routine inventory costs (e.g., shipping costs)
Most companies will likely consider Covid-19 to be unusual or infrequent for purposes of GAAP, but this classification will depend on the business of the borrower and will be within the management’s discretion to make. Borrowers are therefore likely to consider related costs, expenses and losses to be extraordinary, non-recurring or infrequent. Lenders will need to evaluate whether these items meet the above-mentioned classifications in light of the nature of a borrower’s business. For example, the purchase of sanitation supplies and face masks may be ordinary in a food service business but unusual in a software business.
Business Interruption Insurance
Credit agreements also generally contain an addback for insurance proceeds actually paid (without duplication of amounts already included in net income) or expected to be paid under third-party insurance policies, including for business interruption insurance covering a loss of income following a disaster or other covered event. Although the addback is not typically subject to a dollar cap, there are limitations on this addback in even the most borrower friendly formulations. There will generally be a requirement that, if not yet paid, the proceeds will be paid within a specified period of time (e.g. 180-360 days) and that the borrower has some “reasonable expectation” or believes in “good faith” that the proceeds will actually be paid in the required timeframe.
Business interruption insurance coverage is generally related to losses stemming from property damage caused by a natural disaster, such as a hurricane, tornado or flood. After the 2003 outbreak of Sars and resulting losses in the hospitality industry, insurance providers began removing communicable disease coverage from policies. Coverage for lost revenues associated with Covid-19 and the economic shutdown are not anticipated to be universally covered by business interruption insurance. Lenders should ensure a borrower has evaluated any expected insurance proceeds in the context of the specific terms of their business interruption insurance policy.
Lost Revenue
The largest “loss” associated with Covid-19 is expected to be lost revenue for most businesses. Adjusted EBITDA typically does not include a dedicated addback for lost revenues, and to the extent a credit agreement does not contain a lost revenue addback, borrowers may attempt to classify lost revenue as a loss for purposes of the (i) extraordinary, non-recurring or unusual or (ii) discontinued operations addbacks. This should not be permitted.
Even in the most borrower friendly credit agreements, the basis of adjusted EBITDA is net income calculated in accordance with GAAP. The concept of “lost revenue” does not exist under GAAP as a component of net income. Revenues are either earned and recorded on the income statement or not earned and altogether outside of the realm of net income under GAAP.
Lost revenues generally will not be permitted to be added back in the calculation of adjusted EBITDA unless a credit agreement contains a dedicated addback for lost revenues. This is not common, other than in select upper market transactions, but lenders should evaluate this in the context of each transaction.
Our team has extensive experience assisting clients with financing matters, let us know if you have any questions at info@bhlegal.ca.
