Over-adjusted EBITDA? A review of synergies and the related controls in loan agreements

A regular negotiation point on leveraged finance transactions is how EBITDA (earnings before interest, taxes, depreciation, and amortisation) may be adjusted to reflect a truer and more accurate position of group earnings. 

For reference, the Loan Market Association's leveraged finance facility agreement template includes certain optional EBITDA adjustments. These relate to the EBITDA attributable to acquisitions and disposals made during the relevant testing period. This position is usually uncontroversial. 

However, other adjustments to EBITDA have now become commonplace in the mid-market, borne from sponsors and other investors wanting greater flexibility as they look to comparable terms achieved in the large-cap market. 

These other adjustments to EBITDA are focused on synergies. Understandably, the impact of synergies is scrutinised given the effect can be to increase EBITDA significantly, which directly impacts a wide range of key credit protections including, but not limited to: financial covenant testing, accessing further indebtedness, margin ratchets, accession of material companies and size of permitted baskets. 

What are synergies?

The Oxford Dictionary (and a helpful starting point for those less familiar) defines synergies as "the extra energy, power, success, etc. that is achieved by two or more people, companies or elements working together, instead of on their own".

Companies can harness shared knowledge and infrastructure through acquisitions of similar businesses, investments in relevant joint ventures and/or disposals of businesses surplus to requirements, which then reconfigure the group against which EBITDA is tested. The argument exists that these synergies should then be applied to EBITDA to adjust that calculation in an attempt to reflect a truer, fairer and more accurate position to the benefit of the group.  

Mid-market leverage finance has remained largely resolute in not including "revenue synergies" (which differ from the aforementioned "cost synergies") as permitted adjustments to EBITDA. In the context of bolt-on acquisitions, the cost synergy represents the reduction of overall costs after the acquisition and the revenue synergy represents the increased revenue that is made (or modelled to be made) after the acquisition. The former is arguably less speculative and more certain in its quantification, hence why lenders are willing for cost synergies to be included as an adjustment to EBITDA. 

Common controls

There are some lender-led controls on cost synergy adjustments to EBITDA that are regularly seen in leveraged finance transactions:

• Hard caps: the most definitive control is by having a hard cap on synergies. This is most regularly seen as a cap against a percentage of EBITDA (prior to the relevant adjustments) but occasionally an agreed fixed amount can be used as the cap, although the former provides greater flexibility. Across the last five years there has been a gradual increase in the size of the hard caps used. We also occasionally encounter exceptional items (as that common term is used in leveraged finance transactions) being included in this hard cap on permitted synergies. 
• Limits on self-certification: it is typical to see certification in respect of the anticipated synergies from a suitably senior member of management, usually the CFO and/or CEO. We also regularly see this self-certification formalised within a compliance certificate. This certification as to the synergies being reasonably achievable is required to be accompanied by calculations, explanations and assumptions (each in reasonable detail). It is relatively market standard for the requirements on certification to ratchet up with every x% of EBITDA increase, with the final ratchet prior to hitting the hard cap usually requiring independent third-party certification. Lenders will often seek reliance on such third-party certification, but third parties will often couch this reliance behind numerous assumptions and reservations which go some way to undermining this form of lender protection. 
• Time periods: it is very common to see a requirement that the synergies must be realised within 12 months of completion or commencement date of the relevant acquisition, investment, disposal or incurrence. The details of the realisation itself should form part of the certification with an additional focus on whether actual realisation or projected realisation is acceptable. As one moves up the mid-market in size of transaction, synergy realisation periods tend to increase, along with at times a bifurcation of synergies being "actionable" versus when it is "realised or achievable"; that is, the synergy must be first actionable within [x] months of the relevant synergy event and then also realised or achievable within [x+y] months.

Group initiatives 

The synergies described above emanate from fixed transactions such as acquisitions, disposals and joint ventures and, due to their nature, the related synergies are more easily quantifiable. Some sponsors and companies seek to include a broader type of synergy stemming from restructurings, reorganisations, investment programmes, operational improvements and/or similar initiatives. These are known as group initiatives and, due to their nature, are considered more speculative and so are sometimes resisted by lenders. 

When included as a permitted synergy, there are a couple of specific controls. A bespoke hard cap of pre-adjusted EBITDA exists in addition to hard caps aggregated across synergies. There is also a requirement that there shall be no double counting with respect to any exceptional items; if any item constitutes both an exceptional item and a group initiative, it shall count as a group initiative as it is then subject to the bespoke hard cap.

Osborne Clarke comment

What constitutes a permitted synergy will continue to feature as part of scrutinised negotiations in leveraged finance transactions. This is unavoidable. 

An understanding of this, combined with a balancing act of sponsor discretion and the setting of lender parameters, means an agreed position is usually achievable and can often be expanded upon as the sponsor-lender relationship grows based on successful historic investment precedents which demonstrated sensible applications of the power of adjusted EBITDA through synergies.