ZZetaCracked
Sign in
Chapter 2 of 5 · 11 min

Credit statistics: what lenders will allow

Leverage, interest coverage and loan-to-value: the ratios that decide how much debt a buyout can carry.

By the end of this chapter you can
  • Calculate senior and total leverage
  • Calculate interest coverage, before and after capex
  • Calculate loan-to-value and the equity cushion
  • Work out the most debt a coverage floor allows
1

The intuition

A mortgage lender asks three questions. How many years of your income is the loan? Does your monthly pay comfortably cover the payments? And how far could the house price fall before the loan is bigger than the house?

Buyout lenders ask the same three, in their own words: leverage, interest coverage and loan-to-value. The answers decide how much they will lend.

The key idea

Leverage = debt ÷ EBITDA. Coverage = EBITDA ÷ interest. Loan-to-value = debt ÷ enterprise value. Each can be turned around to give the most debt the business can carry under a limit.

2

Why it works

  • Leverage is quoted for the senior debt and for the whole stack. Each lender cares most about the debt ranking alongside or ahead of it, so a deal can be comfortable for the senior lenders and aggressive in total.
  • Interest coverage = EBITDA ÷ interest: how far earnings can fall before the interest is in doubt. Coverage after capex is the stricter version, because a business that must keep reinvesting cannot hand all of its EBITDA to lenders.
  • The blended rate is total interest ÷ total debt. Junior debt costs more because it ranks behind the senior.
  • Loan-to-value = total debt ÷ enterprise value. The equity cushion, 1 − loan-to-value, is how far value can fall before lenders are impaired.
  • A coverage floor sets a debt ceiling: the most interest allowed is EBITDA ÷ floor, and the most debt is that interest ÷ the blended rate.
  • Floating-rate debt moves with base rates, so a rate rise cuts coverage without the business doing anything wrong.
EBITDA $100M at 10x; senior 4.0x at 7%; junior 1.0x at 10%; capex $15M
Total leverage: (400 + 100) ÷ 1005.0x (senior 4.0x)
Interest: 400 × 7% + 100 × 10%38
Coverage: 100 ÷ 382.63x
Coverage after capex: (100 − 15) ÷ 382.24x
Loan-to-value: 500 ÷ 1,00050% (cushion 50%)
Most debt at a 2.0x floor: 100 ÷ (2.0 × 7.6%)658, or 6.58x
Rates up 2 points: 100 ÷ 482.08x

The blended rate is 38 ÷ 500 = 7.6%.

3

The formulas

Total leverage = total debt ÷ EBITDA; senior leverage = senior debt ÷ EBITDA

Years of earnings the debt represents.

Blended rate = (senior × senior rate + junior × junior rate) ÷ total debt

The average cost of the stack.

Interest coverage = EBITDA ÷ interest

How many times earnings cover the interest.

Coverage after capex = (EBITDA − capex) ÷ interest

The cash-based version.

Loan-to-value = total debt ÷ enterprise value; equity cushion = 1 − LTV

How far value can fall before lenders lose.

Max debt at a coverage floor = EBITDA ÷ (floor × blended rate)

Coverage turned into a debt limit.

4

Worked example

Total the interest across both tranches, then divide EBITDA, and EBITDA less capex, by it.

Drawing the numbers…
5

See it move

Same deal. Change how much senior and junior debt there is, the senior rate, the price and the capex.

Drawing the numbers…
Try this
  • Add junior debt. Total leverage and the blended rate rise, senior leverage does not, and coverage falls.
  • Raise the senior interest rate. Leverage and loan-to-value do not move, but coverage falls.
  • Raise capex. EBITDA coverage is unchanged, while coverage after capex falls.
  • Raise the entry multiple. Loan-to-value falls and the equity cushion grows, while leverage and coverage stay put: lenders size off EBITDA, not price.
6

Run it backwards

Same deal, reversed: lenders set a minimum coverage. What is the most debt the business can carry?

Drawing the numbers…

Coverage is EBITDA ÷ interest, so a floor caps interest at EBITDA ÷ floor. Interest is debt × the blended rate, so divide that interest cap by the rate to get the debt cap, then by EBITDA for turns.

When rates are high, coverage is usually the limit that binds; when rates are low, lenders run out of comfort on leverage first.

7

Traps

Relying on EBITDA coverage alone.
A business that must reinvest cannot pay all of its EBITDA to lenders. Look at coverage after capex too.
Quoting only total leverage.
Senior lenders judge senior leverage; the whole stack matters to junior lenders and rating agencies. Give both.
Forgetting that most buyout debt floats.
A rise in base rates raises interest and cuts coverage immediately, unless the debt is hedged.
Measuring loan-to-value against book value.
Use enterprise value: what the business would sell for, which is what lenders would recover from.
Treating the coverage ceiling as the target.
It is the most debt allowed, with no room for a bad year. Structures are set below it.
8

Say it in the interview

The interviewer asks

“What credit statistics do lenders look at when sizing debt for an LBO?”

Say yours out loud first, then compare.
9

Check yourself

4 fresh questions, with new numbers. Answer each one correctly to finish the chapter. Get one wrong and you will see the full working, then you can try it again with new numbers.

Answers within 1% are marked right. Type the number; $, %, x and M are fine. First tries count toward Learned: the topic is Learned once every chapter is done and 75% of first tries were right.

0 of 4
Drawing your questions…
Remember
  • Leverage = debt ÷ EBITDA, senior and total.
  • Coverage = EBITDA ÷ interest; after capex is stricter.
  • Loan-to-value = debt ÷ EV; the cushion is the rest.
  • Max debt at a floor = EBITDA ÷ (floor × blended rate).