LA broadcast: The increasing prevalence of aggressive EBITDA adjustments

Operators and investors,

As I’m spending the second half of March between strategic meetings in Los Angeles, I’ve already sat in nearly a dozen meetings around valuations and M&A opportunities - between executive leaders and PE partners, M&A advisors and microcap PE firms, PR consultants fielding opportunities, and consultants scouting for available deals.

Some financial, most strategic deals, but all tied to company health and financial performance (usually calculated differently in each deck or P&L report).

The elephant in the M&A room

EBITDA adjustments are undergoing an extreme cycle that is nearing the tipping point. The hard truth is that many PE firms are still signing off on reporting adjustments that obscure the real P&L performance & operational health.

I recently reviewed a target company's financials for a $70M acquisition where adjustments sliced "non-recurring" expenses by nearly 20% from their unadjusted EBITDA, turning a modest profit into a strong one, mostly through reclassifying ongoing operational costs.

What was previously considered creative accounting is now flagged as a dangerous practice that inflates valuations, misleads LPs, and creates immense pressure on operating partners post-acquisition. The traditional arbitrage model of buying low & selling high is already under pressure, and these kinds of aggressive adjustments only exacerbate the problem by baking in unrealistic expectations from day one.

The illusion of adjusted EBITDA

Aggressive EBITDA adjustments have become a widespread trick to make target companies look more attractive, especially in competitive bidding environments.

This practice isn't new, but its frequency & audacity have grown, turning what should be a transparent financial metric into an opaque exercise in wishful thinking. Many "one-time" expenses often recur, just with different names, or they represent essential investments that can't simply be cut without impacting future growth.

• Misleading operational health. Add-backs like "owner's compensation adjustments" or "non-recurring legal fees" can hide systemic issues. I saw one deal where a $3M "restructuring cost" add-back was a recurring annual expense under different budget lines.

• Inflated valuations & multiples. When EBITDA is artificially boosted, the resulting enterprise value, often based on a major-15x multiple, becomes detached from reality. This means buyers are overpaying for businesses that will struggle to meet pro forma projections.

• Post-acquisition pressure. Operating partners are then left to achieve unobtainable EBITDA targets, often leading to unsustainable cost-cutting measures that cripple long-term value creation.

Scrutinizing beyond "adjusted" figures

For LPs & GPs, the solution isn't just more diligence, but SMARTER diligence, focusing on the underlying cash flows & operational drivers. You can't rely on headline numbers when those headlines are heavily edited.

It requires a deeper dive into the specific nature of each adjustment & its recurrence probability.

• Forensic P&L analysis. Don't just accept the adjustments. Map each add-back to general ledger accounts & scrutinize its recurrence over the last 3-5 years. I recently advised on a deal where $1.5M in "extraordinary maintenance" was added back annually for five years straight.

• Cash flow reconciliation. Always cross-reference adjusted EBITDA to actual cash flow from operations. Healthy companies generate consistent operating cash, regardless of accounting adjustments. A gap larger than typical working capital variations should raise red flags.

• Operational detailed look. Engage with current management to understand the why behind each adjustment. Is a "strategic consulting" expense truly one-time, or is it covering a core function that will need replacing? Does the sales team actually require a $500K annual "retention bonus" because their base pay is low?

The long-term impact on portfolio performance

The short-term gain of a higher entry multiple from aggressive adjustments often leads to significant long-term pain.

Portfolio companies struggle to hit targets, requiring more capital injections or asset write-downs. This impacts the fund's overall IRR & erodes LP trust, making future fundraising harder. We're seeing more LPs conducting their own operational diligence, going beyond the glossy CIMs.

• Eroding trust & LP confidence. Funds that consistently fail to meet projected returns due to over-adjusted targets eventually face skepticism during subsequent fundraising rounds. LPs want real performance, not accounting gymnastics.

• Operational strain. Management teams within portfolio companies are pushed to deliver unrealistic numbers, fostering a culture of short-termism over sustainable growth. This often results in talent churn & a decline in product quality or customer service.

• Impaired exit opportunities. When it comes time to exit, these same adjustments come under scrutiny again, often leading to lower-than-expected sale prices as new buyers apply more realistic EBITDA figures.

This week, review one of your recent portfolio companies’ performance against their original adjusted EBITDA projections. Look for discrepancies & understand the root causes.

If something doesn’t add up, reply for some high-level overview from an outside operating partner.

Mario

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