Debt capacity: three tests, one answer
Leverage, 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
The intuition
A mortgage lender checks three things before deciding how much to lend you. A multiple of your salary. Whether your monthly pay covers the repayments with room to spare. And a share of the house's value, so there is a deposit underneath the loan. You get the smallest of the three answers.
Buyout lenders run the same three tests. Which one bites depends on the deal, and above all on interest rates: when money is cheap the salary-multiple test binds; when rates rise, the can-you-pay test takes over.
Leverage cap = max turns × EBITDA. Coverage cap = EBITDA ÷ (minimum coverage × rate). LTV cap = max LTV × enterprise value. Capacity is the smallest.
Why it works
- Leverage caps debt at a multiple of EBITDA. It guards against paying too much for earnings that may not last.
- Interest coverage requires EBITDA to be a set multiple of interest. The most interest is EBITDA ÷ that multiple, so the most debt is that interest ÷ the rate. It guards against a rate or earnings shock.
- Loan-to-value caps debt at a share of enterprise value, so there is equity beneath the loan if it has to be recovered.
- Only the coverage cap depends on the rate. Set it equal to the leverage cap and EBITDA cancels: coverage binds above a rate of 1 ÷ (max turns × minimum coverage).
- Only the LTV cap depends on the price. When it binds, a higher purchase price oddly raises capacity, because that lender sizes off value rather than cash flow.
- Rate rises hit twice. More interest on whatever you borrow, and less you can borrow in the first place. The sponsor fills the gap with equity, or the price comes down.
| Leverage cap: 5.0 × 100 | 500 |
| Coverage cap: 100 ÷ (2.5 × 9%) | 444 |
| LTV cap: 55% × 900 | 495 |
| Capacity: the smallest | 444 (coverage), 4.44x |
| Coverage binds above: 1 ÷ (5.0 × 2.5) | 8.0% |
| Rates up to 11%: 100 ÷ (2.5 × 11%) | 364, so 80 lost |
The formulas
A multiple of earnings.
The most interest allowed, divided by the rate.
A share of what the business is worth.
The tightest test decides.
Where the first two caps are equal.
Worked example
Work out all three caps, then take the smallest and say which test it was.
See it move
Same company. Change the rate and each of the lenders' limits.
- Raise the interest rate. Only the coverage cap falls, and capacity falls with it once coverage is the smallest.
- Raise the purchase multiple. Only the loan-to-value cap rises, so capacity rises only if that test was the one binding.
- Raise the leverage cap. The rate at which coverage binds falls: coverage takes over sooner.
- Raise the minimum coverage. The coverage cap falls, and so does the rate at which it takes over.
Run it backwards
Same lenders, reversed: at low rates the leverage cap limits the loan. Above what rate does coverage bind instead?
Write the two caps side by side: max turns × EBITDA, and EBITDA ÷ (minimum coverage × rate). Set them equal and EBITDA cancels, leaving rate = 1 ÷ (max turns × minimum coverage).
It needs no company figures at all, which makes it a good interview shortcut: at 6.0x and 2.0x coverage, anything above 8.3% means coverage, not leverage, sets the debt.
Traps
Say it in the interview
“How do lenders decide how much debt a buyout can carry?”
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.
- Three caps: leverage, coverage, loan-to-value. Lend the smallest.
- Coverage cap = EBITDA ÷ (coverage × rate).
- Coverage binds above rate = 1 ÷ (turns × coverage).
- Higher rates cut capacity with no change in EBITDA.