Run-Rate EBITDA: a Worked Example

The case for run-rate is fair as far as it goes. A business that won a large contract three months ago carries three months of it in its LTM EBITDA, and the next twelve months will carry all twelve. Testing it on the past year alone understates what it will earn, and a borrower raising debt now wants the debt sized on the business it has now.

The lender's difficulty is that a run-rate is a forecast dressed as a record. The months chosen to annualise are usually recent and usually good, the contract may not renew, the price rise may cost volume, and savings planned are not savings made. Debt is repaid from cash actually earned. The Bank of England, writing about leveraged lending in 2018, made the general point: adjustments that assume future earnings improvements are uncertain in both size and timing, and may overstate EBITDA and so understate leverage.

The first method is quick and crude: it carries whatever was unusual about the latest period into a whole year, including its season. The second is the one a lender can test, because each item is separate. A new contract is annualised at its contracted volume and margin. A price increase is counted for the months it was not yet in force. Cost savings are counted at their full annual value less what has already come through. For each, the lender asks what evidence exists today: a signed contract and invoices issued, a price list customers have accepted, a headcount that has already fallen.

When run-rate items are allowed into a covenant, most often in sponsor-backed and leveraged facilities, the agreement usually attaches conditions. Common ones are that the savings are expected to be realised within a stated period after the action is taken, that a director certifies them, and that they are capped, often together with other adjustments, as an amount or a share of EBITDA. Items that are not realised in time drop out.

A commercial cleaning contractor, constructed for this page like every figure in it, has LTM EBITDA of US$6.0m and net debt of US$24m. Three months ago it began a hospital contract worth US$1.2m of EBITDA a year. A price rise took effect six months ago, worth US$0.8m a year. A cost programme should save US$1.0m a year, of which US$0.2m is already showing. Its latest quarter was US$1.9m.

Presented in full, the run-rate takes a turn off leverage. The lender's reading separates the items. The contract is signed and running, and the price rise is in force, so their annual effect has evidence behind it: 7.3, or 3.29 times. The unrealised savings have a plan behind them and nothing more. The last line shows a covenant definition that caps all such adjustments at 15% of LTM EBITDA, or US$0.9m; the 15% is the example's, not a market norm. On that basis the contractor tests at 3.48 times, which is what the lender would be agreeing to.

Run-rate sits on top of other measures, and readers often run them together. LTM EBITDA is the base: what was earned in the twelve months to the test date. Pro forma EBITDA adds the earnings of a business acquired during the period for the months before it was owned. Those earnings did happen, under another owner, and can be checked against that business's accounts. A run-rate adds earnings that have not happened under anyone. Synergies from an acquisition sit between the two, because they depend on an integration that has yet to be done.

The order matters to a lender. Each layer is further from cash already received, so the evidence asked for rises with it, and the add-back cap in a facility agreement is usually written to catch the outer layers, not the base.

DEFINED IN ONE PARAGRAPH → · THE CAP ON ADJUSTMENTS → · ADJUSTED EBITDA →

At origination, run-rate decides how much debt the business can raise. A lender sizing debt on 8.1 lends about a third more than one sizing on 6.0, and the difference is repaid only if the future arrives. The credit paper therefore sets out each item, the evidence for it and the amount accepted, so the committee can see which part of the debt rests on earnings already made.

After signing, the definition decides how the covenant behaves. If the savings arrive, they move from the run-rate into LTM and nothing changes. If they do not, they drop out when the realisation period ends and leverage rises with no change in trading that quarter. A lender who tracks the realisation of each item, as part of testing the forecast, sees that step coming; one who does not finds it in a compliance certificate.

TESTING A BORROWER'S FORECAST → · DEBT TO EBITDA →