Debt & Leverage
How much a buyout can borrow, in what form, and how the sponsor lives with it: debt capacity, unitranche versus mezzanine, PIK, covenants and refinancing.
Debt is what puts the leverage in a leveraged buyout, and a private equity associate spends a lot of time on it: sizing it with lenders, choosing its structure, watching its covenants and replacing it when terms improve. This lesson covers those decisions. The mechanics of paying it down, the cash sweep and the debt schedule, are in Investment Banking · LBO Basics.
- The stack, from safest to riskiest. A revolving credit facility for day-to-day cash; senior secured term loans; then junior debt such as notes or mezzanine; sometimes a PIK note at a holding company. Each layer ranks behind the one above and charges more.
- How much. Lenders run leverage, coverage and loan-to-value tests and lend the smallest answer.
- What form. Cheap senior plus expensive mezzanine, or a single unitranche; cash interest or interest paid in kind.
- Living with it. Covenants set a floor under EBITDA, and step-downs raise it. Refinancing swaps the debt when the saving beats the cost.
Every limit is a ratio to earnings or value, so turn it around to get a dollar amount: most debt = EBITDA ÷ (coverage × rate); EBITDA floor = debt ÷ covenant; breakeven = cost ÷ annual saving.
The life of a buyout's debt
From sizing the debt to replacing it. Each step points to the chapters that practice it.
Chapters
Debt capacity: three tests, one answer
11 minLeverage, interest coverage and loan-to-value each cap the debt. Lenders lend the smallest.
- Calculate the debt each lender test allows
- Pick the binding test and state the capacity in dollars and turns
- Find the interest rate at which coverage takes over from leverage
- Show what a rate rise does to capacity
Unitranche versus senior plus mezzanine
11 minOne loan at one rate, or cheap senior debt with expensive mezzanine behind it.
- Calculate the interest bill and blended rate of a two-tranche structure
- Compare it with a unitranche of the same size
- Find the mezzanine rate at which the two cost the same
- Split mezzanine interest into cash and PIK
PIK interest and accreting balances
11 minInterest that is added to the loan instead of paid: cash today, a bigger balance at exit.
- Compound a PIK note to its balance at exit
- Work out how long a PIK note takes to double
- Back out a PIK rate from the balance
- Compare total debt at exit with the coupon paid in cash or in kind
Covenant headroom
11 minHow far EBITDA can fall before the leverage covenant breaks, and how that room shrinks as the covenant steps down.
- Calculate the lowest EBITDA a leverage covenant allows
- Express the room as an EBITDA cushion and as turns of headroom
- Negotiate the covenant level for a target cushion
- Recompute the cushion after a step-down and a change in EBITDA
Refinancing breakeven
10 minPay fees today to save interest every year. How long until it pays back, and the rate that makes it worth it.
- Calculate the annual interest saving from a lower rate
- Calculate the upfront cost: arrangement fee plus call premium
- Work out the breakeven in years and the net benefit by exit
- Find the highest new rate that pays back within a target period