The New Debt Service Coverage Math

Posted on: June 8th, 2023

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Leveraged buyout transactions rely on large amounts of debt to fund the purchase of a controlling interest in a company. The source of funds includes equity, debt funding as well as any rollover equity or seller note left in the deal. Leveraged buyout financiers use several metrics in sizing their loan envelopes such as loan to value, debt service coverage and leverage ratio. These statistics allow the lender to assess the debt capacity of the leveraged buyout candidate relative to the market and internal credit parameters.

The key measure of finance-ability is the borrower’s ability to service the debt at a comfortable coverage ratio at its current level of earnings. This coverage ratio with EBITDA less capex as the numerator and interest and principal payments as the denominator is sensitive to both microeconomic and macroeconomic variables. The Fed has hiked interest rates a total of 4.75% since the beginning of 2022 when the SOFR rate was a mere .25%. If the spread is 300 bps over SOFR, and the loan is $10 million, the interest expense has increased from $325,000 to $775,000 per annum.

If the Company has $3.33 million in EBITDA, and the $10 million is being repaid over a 5-year term, the debt service ratio reduces from 1.43 times to 1.20 times, a 16% decrease. Companies with stable to growing profit lines can absorb this increase without much inconvenience. However, the combination of increased interest cost and decreased earnings can create a painful debt service coverage whipsaw effect. Given the recessionary clouds on the horizon, leverage buyout lenders are approaching deals more cautiously and selecting those deals that have strong backlogs and earnings visibility.

At higher interest costs, the margin of safety relative to sub-zero debt service coverage is diminished. In this example, it takes on a 16% decrease in EBITDA to arrive at 1 times debt service coverage, which is substandard for leverage buyout lenders. This new debt service coverage math, reflecting high interest rates, will result in a flight to deal quality and more restrained debt loads in middle market leveraged buyouts.

As new acquisition financing credit funds pivot to non-private equity sponsored deals, many lack experience with the asset class. Non-sponsored deals such as direct loans to companies or loans to independent sponsors making acquisitions are quite different from private equity backed deals and require a different thought process and engagement style from the lender.

During their underwriting processes, acquisition financing providers analyze probable performance projections for their proposed borrowers. The underwriter often toggles between a few scenarios to sensitize the growth variables leading to slower revenue and margin growth over time. The lender’s underwriting view is usually an extension of its credit intelligence and historical experience.

Mezzanine debt loans occupy the risky echelon beneath the bank but ahead of the equity in a capital structure. They are naturally subordinated to the bank loan via an intercreditor agreement wherein the senior lender retains the power to block their interest or force them to standstill.