Adjusted leveraged credit

What Is Adjusted Leveraged Credit?

Adjusted leveraged credit refers to debt financing extended to companies that already have significant levels of leverage on their balance sheets. It falls under the broader financial category of debt finance and is characterized by the use of non-standard, or "adjusted," financial metrics in the assessment of a borrower's capacity to service the debt. These adjustments typically involve adding back certain non-recurring or non-cash expenses to reported earnings, aiming to present a more favorable view of the borrower's operational cash flow and debt repayment ability. Adjusted leveraged credit is primarily used for transactions such as corporate buyouts, mergers and acquisitions, and recapitalizations, where the acquiring or target company takes on substantial debt.

History and Origin

The concept of leveraged lending, a precursor to adjusted leveraged credit, gained prominence in the 1980s with the rise of leveraged buyouts (LBOs) and junk bonds. However, the use of "adjusted" metrics, particularly Adjusted EBITDA, became more widespread in the 2000s and intensified after the 2008 financial crisis. As competition among lenders increased and market conditions eased, there was a growing tendency to stretch traditional underwriting standards. This led to a greater reliance on pro forma or adjusted figures to justify higher debt levels.

Regulatory bodies began to express concerns about the potential for increased risk in the financial system due to the growth and easing of standards in leveraged lending. In response, the Federal Reserve Board, along with the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC), issued Interagency Guidance on Leveraged Lending in March 2013. This guidance emphasized the importance of sound risk management practices, including robust underwriting standards and realistic repayment assumptions for leveraged transactions.⁵ The guidance highlighted expectations for financial institutions to assess a borrower's ability to de-lever to a sustainable level based on conservative projections, often scrutinizing the "add-backs" used in calculating adjusted metrics.⁴

Key Takeaways

• Adjusted leveraged credit involves high levels of debt and often relies on "adjusted" financial metrics for credit assessment.
• These adjustments typically involve adding back non-cash or non-recurring expenses to earnings.
• It is frequently used in private equity-backed transactions like leveraged buyouts and corporate acquisitions.
• While offering flexibility, the use of adjusted metrics can obscure a company's true debt servicing capacity and increase credit risk.
• Regulatory bodies have issued guidance to ensure prudent underwriting practices in the leveraged lending market.

Interpreting Adjusted Leveraged Credit

Interpreting adjusted leveraged credit requires careful scrutiny beyond headline financial ratios. The core of its interpretation lies in understanding the "adjustments" made to a company's financial performance, most commonly to Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). Lenders and investors assess the borrower's ability to generate sufficient cash flow to cover interest payments and principal amortization. Key metrics include Debt-to-EBITDA and the interest coverage ratio, but when these rely on "Adjusted EBITDA," the quality of the adjustments becomes paramount.

Adjustments might include anticipated cost synergies from an acquisition, one-time expenses, or projected revenue growth. While some adjustments can be legitimate, others may be aggressive or speculative, potentially inflating a company's perceived debt-paying capacity. A high Debt-to-EBITDA ratio based on aggressively adjusted EBITDA suggests higher risk. Similarly, a seemingly healthy interest coverage ratio might mask underlying weaknesses if the earnings figure is heavily pro forma. Evaluating adjusted leveraged credit necessitates a deep dive into the underlying business fundamentals, the sustainability of the adjustments, and the overall capital structure of the borrower.

Hypothetical Example

Consider "Alpha Co.," a manufacturing firm being acquired by a private equity firm, "Beta Partners." Beta Partners plans to finance the acquisition primarily through adjusted leveraged credit.

Alpha Co.'s reported EBITDA for the last twelve months (LTM) is $50 million. However, Beta Partners proposes the following adjustments to calculate "Adjusted EBITDA":

• Add-back of $5 million in one-time restructuring costs incurred in the past year.
• Add-back of $3 million in legal fees related to a past litigation, deemed non-recurring.
• Pro forma adjustment of $7 million for anticipated cost synergies from combining Alpha Co. with a smaller acquisition target planned for the next year.

Based on these adjustments, Alpha Co.'s Adjusted EBITDA would be:
( $50 \text{ million (Reported EBITDA)} + $5 \text{ million (Restructuring Costs)} + $3 \text{ million (Legal Fees)} + $7 \text{ million (Synergies)} = $65 \text{ million (Adjusted EBITDA)} )

Beta Partners then seeks to borrow $325 million in adjusted leveraged credit. Using the Adjusted EBITDA of $65 million, the Debt-to-EBITDA ratio would be:
( \frac{$325 \text{ million (Debt)}}{$65 \text{ million (Adjusted EBITDA)}} = 5.0\text{x} )

If the lender had used the unadjusted EBITDA of $50 million, the Debt-to-EBITDA ratio would be ( \frac{$325 \text{ million}}{$50 \text{ million}} = 6.5\text{x} ). The lower 5.0x ratio, derived from Adjusted EBITDA, makes the deal appear less risky to potential lenders or investors in the syndicated loan market, even though $7 million of that adjustment is based on future, unproven synergies. This highlights how adjustments can significantly alter the perceived leverage of a transaction.

Practical Applications

Adjusted leveraged credit is a fundamental component of the contemporary corporate finance landscape, primarily found in the private debt markets. Its practical applications span several key areas:

• Acquisition Finance: It is widely used to fund large corporate acquisitions, particularly those involving private equity sponsors. The ability to use adjusted metrics allows for higher debt capacities and thus larger deal sizes.
• Leveraged Buyouts (LBOs): In LBOs, a company is acquired using a significant amount of borrowed money, with the assets of the acquired company often serving as collateral. Adjusted leveraged credit facilities are specifically structured for these transactions.
• Refinancing and Recapitalizations: Companies with existing debt may use adjusted leveraged credit to refinance their obligations, often to take advantage of lower interest rates or to extend debt maturities. Recapitalizations may involve issuing new debt to pay a dividend to shareholders.
• Growth Capital: While less common for pure growth, some mature companies may use adjusted leveraged credit to fund substantial expansion projects or strategic initiatives, where pro forma adjustments might justify the increased borrowing.

The robust activity in the leveraged finance market, including the rebound in leveraged loan issuance, indicates its continued importance in corporate financing.³ This type of credit facilitates significant capital movements and corporate restructuring across global markets.

Limitations and Criticisms

While adjusted leveraged credit offers flexibility in financing complex transactions, it also carries notable limitations and criticisms. A primary concern is the potential for "aggressive" adjustments that may inflate a borrower's perceived financial health, leading to an underestimation of default risk. Regulators and market participants have expressed caution regarding the widespread use of such adjustments, particularly during periods of benign credit conditions. For example, the International Monetary Fund (IMF) has highlighted how vulnerabilities can build in corporate sectors during maturing credit cycles, often exacerbated by high levels of leveraged debt.²

Another criticism revolves around the weakening of traditional protective measures for lenders. The rise of covenant-lite loans, which have fewer financial maintenance financial covenants than traditional loans, means that lenders have less ability to intervene or renegotiate terms until a borrower is closer to actual distress.¹ This lack of early warning signals, combined with potentially optimistic "adjusted" figures, can leave lenders and investors exposed to greater losses if economic conditions deteriorate. Critics argue that the reliance on pro forma metrics can mask a company's true debt-servicing capacity, potentially leading to mispricing of risk and systemic vulnerabilities within the financial system.

Adjusted Leveraged Credit vs. Leveraged Loan

While closely related, "adjusted leveraged credit" and "leveraged loan" refer to different aspects of high-debt financing.

Confusion often arises because most leveraged loans are assessed using "adjusted" financial metrics, making them a common form of adjusted leveraged credit. However, not all adjusted leveraged credit necessarily takes the form of a syndicated leveraged loan; it could also apply to certain high-yield bonds or other private debt structures where similar analytical adjustments are made during underwriting and financial modeling. The "adjusted" aspect highlights the specific analytical process that enables or supports the extension of such credit.

FAQs

What kind of "adjustments" are typically made in adjusted leveraged credit?

Adjustments often include adding back one-time or non-recurring expenses (e.g., restructuring costs, legal fees), non-cash items (e.g., stock-based compensation), or pro forma adjustments for expected cost savings or synergies from acquisitions. These are made to reported earnings, typically EBITDA, to arrive at an "Adjusted EBITDA."

Why are these adjustments made?

Adjustments are made to present a normalized or forward-looking view of a company's operational profitability and cash flow, which is then used to assess its capacity to service significant debt. Proponents argue they provide a clearer picture of ongoing business performance, while critics suggest they can sometimes obscure a company's true financial health.

Who provides adjusted leveraged credit?

Adjusted leveraged credit is typically provided by institutional investors, such as collateralized loan obligations (CLOs), private credit funds, hedge funds, and sometimes traditional banks, often through loan syndication arrangements.

What are the risks associated with adjusted leveraged credit?

The primary risks include the potential for exaggerated financial metrics that mask a borrower's true debt burden, leading to higher default risk. Additionally, the prevalence of weaker protective covenants (covenant-lite loans) in this market can reduce lender recourse in adverse scenarios.

How do regulators view adjusted leveraged credit?

Regulators, such as the Federal Reserve and FDIC, have issued guidance emphasizing prudent underwriting and risk management for leveraged lending. They focus on ensuring that financial institutions have sound processes for assessing a borrower's repayment capacity based on realistic assumptions, rather than overly optimistic adjusted figures.