ZZetaCracked
Sign in
Chapter 4 of 5 · 11 min

Covenant headroom

How far EBITDA can fall before the leverage covenant breaks, and how that room shrinks as the covenant steps down.

By the end of this chapter you can
  • 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
1

The intuition

A bank lets you keep an overdraft as long as it never exceeds three months of your salary. With a fixed overdraft, the rule really says your salary must not fall below a certain level. How far your pay can drop before you break it is your cushion.

A leverage covenant works the same way: debt may not exceed a multiple of EBITDA. With the debt fixed, that sets a floor under EBITDA. And many covenants step down each year, raising the floor on schedule, whether or not the business has grown.

The key idea

EBITDA floor = debt ÷ covenant. Cushion = 1 − floor ÷ EBITDA = 1 − actual leverage ÷ covenant. Headroom in turns = covenant − actual leverage.

2

Why it works

  • The conventions here: one maintenance covenant, maximum total debt ÷ EBITDA, tested on today's debt with no paydown assumed. Next year's test uses a stepped-down covenant and next year's EBITDA.
  • The floor. Leverage equals the covenant when EBITDA = debt ÷ covenant. Any lower and the test fails.
  • The cushion is the percentage fall in EBITDA to reach the floor. It depends only on the ratio of actual leverage to the covenant.
  • Lenders usually set covenants 25–35% away from the base case at closing: room for an ordinary bad year, not a disaster.
  • Step-downs assume growth and paydown. If EBITDA does not grow into the tighter covenant, the cushion shrinks even in a good year.
  • A breach hands lenders control of the conversation. The usual responses are an equity cure (sponsor cash counted toward the test, limited in how often it can be used), a covenant reset negotiated for a fee, or repaying debt.
$450M of debt on $100M of EBITDA; covenant 6.0x, stepping down to 5.5x; EBITDA falls 10% next year
Leverage today: 450 ÷ 1004.50x
EBITDA floor: 450 ÷ 6.075
Cushion: 1 − 75 ÷ 10025% (1.5 turns of headroom)
Next year: 450 ÷ 905.00x
Cushion next year: 1 − 5.0 ÷ 5.59.1%
Covenant for a 30% cushion today: 4.5 ÷ (1 − 30%)6.43x
3

The formulas

Actual leverage = debt ÷ EBITDA

Where the company is.

EBITDA floor = debt ÷ covenant

The lowest EBITDA the test allows.

Cushion = 1 − floor ÷ EBITDA = 1 − actual leverage ÷ covenant

How far EBITDA can fall.

Headroom in turns = covenant − actual leverage

The same room, in turns.

Covenant for a target cushion = actual leverage ÷ (1 − target)

Run the cushion backwards.

Next year: cushion = 1 − (debt ÷ next EBITDA) ÷ (covenant − step-down)

A tighter test on new earnings.

4

Worked example

Find the EBITDA at which leverage exactly hits the covenant, then compare it with today.

Drawing the numbers…
5

See it move

Same company. Change today's leverage, the covenant, next year's step-down and next year's EBITDA growth. Leverage stays at least half a turn inside the covenant, so the deal never starts in breach.

Drawing the numbers…
Try this
  • Raise today's leverage. The lowest EBITDA allowed rises and the cushion shrinks.
  • Loosen the covenant. The cushion grows, with the debt and EBITDA unchanged.
  • Raise the step-down. Today's cushion does not move, but next year's shrinks.
  • Lower next year's growth. Next year's cushion falls, and below zero the covenant is breached without a dollar of new debt.
6

Run it backwards

Same company, reversed: the sponsor wants a set cushion at closing. What covenant level should it negotiate?

Drawing the numbers…

Cushion = 1 − leverage ÷ covenant. Rearranged: covenant = leverage ÷ (1 − cushion). A 25% cushion on 4.5x leverage needs a 6.0x covenant.

If the lenders will not go that high, the other route is starting with less debt, which means more equity.

7

Traps

Reading turns of headroom as the cushion.
1.5 turns of headroom is 25% at 4.5x against 6.0x, but a different percentage at other levels. Compute 1 − actual ÷ covenant.
Dividing debt by actual leverage for the floor.
The floor is debt ÷ the covenant multiple: the EBITDA at which leverage reaches the limit.
Ignoring step-downs.
The covenant tightens on schedule. Flat EBITDA with no paydown means a smaller cushion every year.
Assuming a breach means the company is out of cash.
Maintenance covenants can break while there is plenty of cash. It is a test of ratios, and it gives lenders leverage in a negotiation.
Treating an equity cure as a fix.
It fixes the ratio for a quarter, not the earnings. Lenders limit how often it can be used for exactly that reason.
8

Say it in the interview

The interviewer asks

“How do you think about covenant headroom in a leveraged deal?”

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
  • EBITDA floor = debt ÷ covenant.
  • Cushion = 1 − actual leverage ÷ covenant.
  • Covenant for a cushion = leverage ÷ (1 − cushion).
  • Step-downs shrink the cushion unless EBITDA grows or debt falls.