IDEAS home Printed from https://ideas.repec.org/p/fip/fedlwp/94811.html
   My bibliography  Save this paper

EBITDA Add-backs in Debt Contracting: A Step Too Far?

Author

Listed:
  • Miguel Faria-e-Castro
  • Radhakrishnan Gopalan
  • Avantika Pal
  • Juan M. Sanchez
  • Vijay Yerramilli

Abstract

Financial covenants in syndicated loan agreements often rely on definitions of EBITDA that deviate from the GAAP definition. We document the increased usage of non-GAAP addbacks to EBITDA in recent times. Using the 2013 Interagency Guidance on Leveraged Lending, which we argue led to an exogenous increase in non-GAAP EBITDA addbacks, we show that these addbacks increase the likelihood of loan delinquency and default, and also increase the likelihood of the borrower experiencing a ratings downgrade. Greater use of non-GAAP EBITDA addbacks also makes it more likely that lead arrangers lower their loan share exposures through secondary market sales. Our results highlight that covenants based on customized measures of EBITDA hurt loan performance by worsening lead arrangers’ incentives to monitor borrowers and by hampering their ability to take timely corrective actions.

Suggested Citation

  • Miguel Faria-e-Castro & Radhakrishnan Gopalan & Avantika Pal & Juan M. Sanchez & Vijay Yerramilli, 2022. "EBITDA Add-backs in Debt Contracting: A Step Too Far?," Working Papers 2022-029, Federal Reserve Bank of St. Louis.
    • Handle: RePEc:fip:fedlwp:94811
    DOI: 10.20955/wp.2022.029
    as

    Download full text from publisher

    File URL: https://s3.amazonaws.com/real.stlouisfed.org/wp/2022/2022-029.pdf
    File Function: Full text
    Download Restriction: no
    File URL: https://libkey.io/10.20955/wp.2022.029?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    References listed on IDEAS

    as
    1. Li, Ningzhong & Vasvari, Florin P. & Wittenberg-Moerman, Regina, 2016. "Dynamic threshold values in earnings-based covenants," Journal of Accounting and Economics, Elsevier, vol. 61(2), pages 605-629.
    2. Valeri V. Nikolaev, 2010. "Debt Covenants and Accounting Conservatism," Journal of Accounting Research, Wiley Blackwell, vol. 48(1), pages 137-176, March.
    3. Valeri V. Nikolaev, 2010. "Debt Covenants and Accounting Conservatism," Journal of Accounting Research, Wiley Blackwell, vol. 48(1), pages 51-89, March.
    4. Nicolae Garleanu & Jeffrey Zwiebel, 2009. "Design and Renegotiation of Debt Covenants," The Review of Financial Studies, Society for Financial Studies, vol. 22(2), pages 749-781, February.
    5. Rustom M. Irani & Ralf R. Meisenzahl, 2017. "Loan Sales and Bank Liquidity Management: Evidence from a U.S. Credit Register," The Review of Financial Studies, Society for Financial Studies, vol. 30(10), pages 3455-3501.
    6. Sudheer Chava & Michael R. Roberts, 2008. "How Does Financing Impact Investment? The Role of Debt Covenants," Journal of Finance, American Finance Association, vol. 63(5), pages 2085-2121, October.
    7. Ivashina, Victoria, 2009. "Asymmetric information effects on loan spreads," Journal of Financial Economics, Elsevier, vol. 92(2), pages 300-319, May.
    8. Seung Jung Lee & Dan Li & Ralf R. Meisenzahl & Martin Sicilian, 2019. "The U.S. Syndicated Term Loan Market: Who Holds What and When?," FEDS Notes 2019-11-25, Board of Governors of the Federal Reserve System (U.S.).
    9. Yun Fan & Wayne B. Thomas & Xiaoou Yu, 2019. "The Impact of Financial Covenants in Private Loan Contracts on Classification Shifting," Management Science, INFORMS, vol. 65(8), pages 3637-3653, August.
    10. Becker, Bo & Ivashina, Victoria, 2016. "Covenant-Light Contracts And Creditor Coordination," Working Paper Series 325, Sveriges Riksbank (Central Bank of Sweden).
    11. Yihui Wang & Han Xia, 2014. "Do Lenders Still Monitor When They Can Securitize Loans?," The Review of Financial Studies, Society for Financial Studies, vol. 27(8), pages 2354-2391.
    12. Hans B. Christensen & Valeri V. Nikolaev, 2012. "Capital Versus Performance Covenants in Debt Contracts," Journal of Accounting Research, Wiley Blackwell, vol. 50(1), pages 75-116, March.
    13. Nini, Greg & Smith, David C. & Sufi, Amir, 2009. "Creditor control rights and firm investment policy," Journal of Financial Economics, Elsevier, vol. 92(3), pages 400-420, June.
    14. Asher Curtis & Valerie Li & Paige H. Patrick, 2021. "The use of adjusted earnings in performance evaluation," Review of Accounting Studies, Springer, vol. 26(4), pages 1290-1322, December.
    15. Ningzhong Li, 2016. "Performance Measures in Earnings‐Based Financial Covenants in Debt Contracts," Journal of Accounting Research, Wiley Blackwell, vol. 54(4), pages 1149-1186, September.
    16. Laurion, Henry, 2020. "Implications of Non-GAAP earnings for real activities and accounting choices," Journal of Accounting and Economics, Elsevier, vol. 70(1).
    17. Michael R. Roberts & Amir Sufi, 2009. "Control Rights and Capital Structure: An Empirical Investigation," Journal of Finance, American Finance Association, vol. 64(4), pages 1657-1695, August.
    18. Mark T. Bradshaw & Richard G. Sloan, 2002. "GAAP versus The Street: An Empirical Assessment of Two Alternative Definitions of Earnings," Journal of Accounting Research, Wiley Blackwell, vol. 40(1), pages 41-66, March.
    19. Rajan, Raghuram & Winton, Andrew, 1995. "Covenants and Collateral as Incentives to Monitor," Journal of Finance, American Finance Association, vol. 50(4), pages 1113-1146, September.
    20. Kristian S. Blickle & Quirin Fleckenstein & Sebastian Hillenbrand & Anthony Saunders, 2020. "The Myth of the Lead Arranger’s Share," Staff Reports 922, Federal Reserve Bank of New York.
    21. Chen, Han-Chung & Lee, Yen-Jung & Lo, Sheng-Yi & Yu, Yong, 2021. "Qualitative characteristics of non-GAAP disclosures and non-GAAP earnings quality," Journal of Accounting and Economics, Elsevier, vol. 72(1).
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Zhiming Ma & Derrald Stice & Christopher Williams, 2022. "What's my style? Supply‐side determinants of debt covenant inclusion," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 49(3-4), pages 461-490, March.
    2. Prilmeier, Robert, 2017. "Why do loans contain covenants? Evidence from lending relationships," Journal of Financial Economics, Elsevier, vol. 123(3), pages 558-579.
    3. Shan, Chenyu & Tang, Dragon Yongjun & Winton, Andrew, 2019. "Do banks still monitor when there is a market for credit protection?," Journal of Accounting and Economics, Elsevier, vol. 68(2).
    4. Amiraslani, Hami & Donovan, John & Phillips, Matthew A. & Wittenberg-Moerman, Regina, 2023. "Contracting in the Dark: The rise of public-side lenders in the syndicated loan market," Journal of Accounting and Economics, Elsevier, vol. 76(1).
    5. Wang, Jing, 2017. "Debt covenant design and creditor control rights: Evidence from the tightest covenant," Journal of Corporate Finance, Elsevier, vol. 44(C), pages 331-352.
    6. Gustafson, Matthew T. & Ivanov, Ivan T. & Meisenzahl, Ralf R., 2021. "Bank monitoring: Evidence from syndicated loans," Journal of Financial Economics, Elsevier, vol. 139(2), pages 452-477.
    7. Berlin, Mitchell & Nini, Greg & Yu, Edison G., 2020. "Concentration of control rights in leveraged loan syndicates," Journal of Financial Economics, Elsevier, vol. 137(1), pages 249-271.
    8. Hollander, Stephan & Verriest, Arnt, 2016. "Bridging the gap: the design of bank loan contracts and distance," Journal of Financial Economics, Elsevier, vol. 119(2), pages 399-419.
    9. Freudenberg, Felix & Imbierowicz, Björn & Saunders, Anthony & Steffen, Sascha, 2017. "Covenant violations and dynamic loan contracting," Journal of Corporate Finance, Elsevier, vol. 45(C), pages 540-565.
    10. Christensen, Hans B. & Macciocchi, Daniele & Morris, Arthur & Nikolaev, Valeri V., 2022. "Financial shocks to lenders and the composition of financial covenants," Journal of Accounting and Economics, Elsevier, vol. 73(1).
    11. Zahn Bozanic & Maria Loumioti & Florin P. Vasvari, 2018. "Corporate Loan Securitization and the Standardization of Financial Covenants," Journal of Accounting Research, Wiley Blackwell, vol. 56(1), pages 45-83, March.
    12. Lin, Luca X., 2022. "Taking no chances: Lender concentration and corporate acquisitions," Journal of Corporate Finance, Elsevier, vol. 76(C).
    13. Hans B. Christensen & Valeri V. Nikolaev, 2012. "Capital Versus Performance Covenants in Debt Contracts," Journal of Accounting Research, Wiley Blackwell, vol. 50(1), pages 75-116, March.
    14. Kang, Di & Zhuang, Zhuang, 2019. "Should companies care who their lender is? Evidence from loan covenants," Pacific-Basin Finance Journal, Elsevier, vol. 57(C).
    15. Isin, Adnan Anil, 2018. "Tax avoidance and cost of debt: The case for loan-specific risk mitigation and public debt financing," Journal of Corporate Finance, Elsevier, vol. 49(C), pages 344-378.
    16. Daher, Mai M. & Ismail, Ahmad K., 2018. "Debt covenants and corporate acquisitions," Journal of Corporate Finance, Elsevier, vol. 53(C), pages 174-201.
    17. Chao‐Jung Chen & Wen He & Chien‐Ju Lu & Xin Yu, 2022. "Bank loan covenants, accrual quality and firms’ information environment," Accounting and Finance, Accounting and Finance Association of Australia and New Zealand, vol. 62(1), pages 547-575, March.
    18. Bushman, Robert & Gao, Janet & Martin, Xiumin & Pacelli, Joseph, 2021. "The influence of loan officers on loan contract design and performance," Journal of Accounting and Economics, Elsevier, vol. 71(2).
    19. Roberts, Michael R., 2015. "The role of dynamic renegotiation and asymmetric information in financial contracting," Journal of Financial Economics, Elsevier, vol. 116(1), pages 61-81.
    20. Daniel Cohen & Bin Li & Ningzhong Li & Yun Lou, 2022. "Major government customers and loan contract terms," Review of Accounting Studies, Springer, vol. 27(1), pages 275-312, March.

    More about this item

    Keywords

    syndicated loans; credit agreements; financial covenants; EBITDA; add-backs; GAAP; leveraged lending guidance; borrower performance; loan performance; lead arranger; lender monitoring; loan sales;
    All these keywords.

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G34 - Financial Economics - - Corporate Finance and Governance - - - Mergers; Acquisitions; Restructuring; Corporate Governance

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:fip:fedlwp:94811. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Anna Oates (email available below). General contact details of provider: https://edirc.repec.org/data/frbslus.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.