Case 027Debt capacity and loan structuringCore

What leverage would you offer Nirvaka Diagnostics, a lab chain with EBITDA of Rs 240 crore, 90% cash conversion, low capex and 15% growth?

Golub CapitalChicago · 2015

The situation

Nirvaka Diagnostics runs pathology labs and collection centres across two states. EBITDA is Rs 240 crore. Capex is low, about Rs 24 crore a year, so 90% of EBITDA turns into cash before interest and tax; depreciation roughly equals capex. The sponsor's plan grows EBITDA 15% a year by opening centres.

Your fund's policy for a business like this: the loan must be repayable from free cash flow after interest and 25% tax within seven years, and EBITDA must cover interest at least 2.0 times. The loan would price at 11%.

Your task

Give a leverage indication, show which test sets it, and say how much of the sponsor's growth you are willing to lend against.

Quick check

Which test do you expect to set the leverage number?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

About 4.0x to 4.36x EBITDA, Rs 960 to 1,047 crore, set by the seven-year payback test with half the growth credited. Interest cover of 2.0x at 11% would allow 4.55x, and the sponsor's full 15% growth would allow 5.5x. A lender lends on a case the business can hit if new centres disappoint, so the payback test with growth haircut to 7.5% binds.

Step 1What does a leverage indication actually rest on?

Think of a bank deciding how large a home loan to give. It checks the monthly payment against salary, and it checks how long repayment takes; it offers the smaller of the two answers. A leverage indication is the tightest of several independent tests, never one ratio on its own. For Nirvaka the two tests are cover, how comfortably EBITDA pays interest, and paybackHow many years of free cash flow, after interest and tax, it takes to repay the whole loan., how quickly cash flow clears the principal.

Step 2What does each test allow?

Cover first, because it needs no model. At 2.0x, interest may be at most Rs 120 crore, and at 11% that is Rs 1,091 crore of debt, 4.55x. Payback needs a small model: each year cash flow is EBITDA less Rs 24 crore of capex, less interest on the opening balance, less 25% tax on EBITDA minus depreciation minus interest, and all of it repays debt. Credit all 15% growth and the loan could be 5.5x; credit none and it falls to 3.48x. At 4.36x, year one's interest is Rs 115 crore, tax Rs 25 crore and cash flow Rs 76 crore.

Each test gives a leverage ceiling; the indication sits at the tightest credible onePayback, no growth (downside)3.48xfloor, not the lending casePayback, half the growth4.36xbindsInterest cover 2.0x at 11%4.55xpassesPayback, all 15% growth5.47xsponsor's case0x1x2x3x4x5xIndication 4.0x to 4.36xRs 960 to 1,047 crore
Seven-year payback allows 3.48x with no growth, 4.36x with half the growth and 5.47x with all of it, while 2.0x interest cover at 11% allows 4.55x; the indication of 4.0x to 4.36x sits at the tightest test a lender believes.
Step 3How much of the sponsor's growth do you lend against?

Half, and say why. Fifteen per cent growth depends on new centres filling up, which is the part of the plan most likely to slip, while the existing labs throw off steady cash. Lend on the cash the business already makes, give partial credit for growth, and let the sponsor's equity own the rest of the upside. The picture below shows what that choice protects: the same loan clears in six years if the plan works, exactly in seven at half the growth, and leaves Rs 367 crore outstanding if growth stops entirely.

The same Rs 1,047 crore loan under three growth paths, Rs crore2505007501,0000yr 0yr 1yr 2yr 3yr 4yr 5yr 6yr 7Rs 367 crstill owed, no growthall 15% growth: repaid inside year 6half the growth, 7.5%: zero in year 7no growth: debt left at year 7
A Rs 1,047 crore loan is repaid inside six years at 15% growth, reaches zero in year seven at 7.5% growth, and still has Rs 367 crore outstanding after seven years if EBITDA never grows.

Close the pitch the way a credit committee hears it: 4.0x to 4.36x, with pricing at 11% and cover of about 2.1x on day one. The limits are worth naming. Diagnostics carries reimbursement and pricing risk from large hospital and insurer customers, so ask for customer concentration, and test the no-growth case against a covenant set with 25% to 30% EBITDA headroom.

Where candidates lose it

The usual loss is quoting the most generous test. Cover at 4.5x sounds reasonable, so candidates offer 4.5x without checking payback, which is the test that actually binds once growth is haircut.

The second is taking the sponsor's growth at face value. Lending against 15% compounding gives 5.5x, which is the equity case, not the debt case. Say how much growth you credit and why.

What the interviewer asks next

  • The sponsor asks for 5.0x. What structure or terms would you need to get there?
  • How would a 1.5% rise in the loan rate change your indication?
  • What covenant package would you attach at 4.25x?
  • How would your view change if 40% of revenue came from one insurer?

Asked at Golub Capital, Leveraged Finance, Chicago, 2015 (Wall Street Oasis): What do you think is an appropriate leverage indication for a business with XYZ characteristics?

Company names and figures are illustrative.