Which EBITDA add-backs hold up in LMM diligence and which don't?

When evaluating EBITDA add-backs in LMM diligence, the key is to focus on substantiation and reasonableness. Here's a breakdown based on the most helpful WSO content:

Add-Backs That Usually Hold Up

1. One-Time Legal or Professional Fees: These are typically backed by invoices and are clearly non-recurring.
2. Owner Compensation Above Market Replacement: If the seller's compensation exceeds what a market-rate replacement would cost, the excess is a valid adjustment.
3. Documented Non-Recurring Items: Examples include settlements or one-off events like a relocation. Proper documentation is critical.

Add-Backs That Usually Get a Haircut

1. "Normalizing" Owner Perks Without Replacement Hires: Perks like personal travel or vehicles often lack a clear replacement cost and are heavily scrutinized.
2. Pro Forma Savings from Cuts Not Yet Made: These are speculative and often discounted unless there's a clear, actionable plan.
3. Revenue from Contracts Signed but Not Started: Future revenue is uncertain and typically excluded unless highly predictable.
4. "One-Time" Items That Recur: If an item labeled "one-time" appears consistently over multiple years, it loses credibility.

Case-by-Case Add-Backs

1. Related-Party Rent: The key question is whether the rent is at market rates. If not, adjustments may be warranted.
2. Run-Rate Adjustments for New Pricing: These depend on the timing and certainty of the pricing changes.

Tests to Apply

1. Invoice or Payroll Record Tie-Back: Can the add-back be directly tied to a specific invoice or payroll record? If yes, it’s more likely to hold up.
2. Replacement Owner Test: Would a replacement owner realistically save this cost? If not, the add-back is questionable.

Pushback Strategy

Start by challenging speculative or poorly documented add-backs, such as pro forma savings or recurring "one-time" items. These are often the weakest and easiest to discount.

Sizing a Haircut

Instead of arguing line by line, consider: - Benchmarking: Compare the add-back to similar adjustments in comparable deals. - Partial Acceptance: Accept a portion of the add-back based on the level of documentation or likelihood of realization. - Scenario Analysis: Model the impact of including or excluding the add-back to show its materiality.

This approach ensures a balanced and defensible position during negotiations.

Sources: Private Credit Questions, Sources and Uses: How to Find and Use Information in IBD (EBITDA example), EBITDA vs. Operating Cash Flow vs. Free Cash Flow, Framework for Understanding Results, Alternative Lenders & the End of Risk Taking for Banks - Opportunity or Risk?