Adjusted EBITDA add-backs are inflating leverage ratios in leveraged loans and direct lending, masking underlying financial fragility, per Financial Times analysis. These adjustments, which inflate reported earnings by including non-recurring items like projected synergies, have expanded materially over the past decade as credit documentation weakens. In leveraged loans, reported debt-to-EBITDA dropped to 4.6x, but actual leverage is closer to 5.9x. Direct lending shows an even starker gap, with reported 5.0x falling to 6.9x. This discrepancy leaves lenders with thinner equity cushions, increasing risk profiles. The trend is particularly acute in software acquisitions, where high valuations and leverage compress during downturns, driving mark-to-market loan-to-value ratios higher.

The data reveals a clear link between aggressive add-backs and missed targets. S&P Global's 8-year study found companies failed to meet initial Adjusted EBITDA targets 92% of the time within the first year, resulting in leverage that was 2.3 turns higher in year one and 2.7 turns higher in year two. These aggressive adjustments are concentrated among single-B issuers, highlighting the problem's severity in direct lending and leveraged loan markets. The zero-interest rate era fueled this dynamic, enabling private equity roll-up strategies based on optimistic projections that often failed to materialize.

Looser credit documents not only enable larger EBITDA add-backs but also facilitate liability management exercises, allowing companies to extend maturities or capture discounts on debt, often leaving creditors with unfavorable terms. This combination contributed to declining leveraged loan recoveries, falling to 36 cents on the dollar in 2025 from 60 cents a decade prior. The younger direct lending market is showing similar downward trends. Until the loose definitions of Adjusted EBITDA are reined in, leverage ratios will continue to flatter borrowers, leaving investors facing the critical question: What happens when the add-backs don't add up?