Case 036Leveraged finance and LBO financingCore

Leveraged finance case: size and price the debt for a sponsor buyout of Zorvani Chemicals, EBITDA Rs 250 crore, where comparable deals ran at 4.5x to 5.0x. Propose senior and second lien tranches and check interest cover.

The situation

A sponsor is buying Zorvani Chemicals, a maker of specialty additives for paints and plastics, on EBITDA of Rs 250 crore. Capex and depreciation are both about Rs 40 crore a year and tax is 25%. Recent buyouts of similar chemicals businesses were financed at 4.5x to 5.0x total leverage.

Your desk can place senior term loans at about 10.5% up to 3.5x EBITDA, and second lien debt behind it at about 13%. Your credit committee will not underwrite a structure with EBITDA to cash interest below 2.0x.

Your task

Propose a tranche structure with multiples and pricing, check cover, and say where in the comparable range you land and why.

Quick check

Keeping senior at 3.5x, how far can second lien take total leverage before cover drops below 2.0x?

Worked solution

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

30-second answerThe answer to give first

Senior term loan 3.5x, Rs 875 crore at 10.5%, and second lien 1.0x, Rs 250 crore at 13%: 4.5x in total with cover of 2.01x. That is the bottom of the 4.5x to 5.0x comparable range, and cover is why. Interest totals Rs 124.4 crore; at 5.0x it would be Rs 140.6 crore and cover would fall to 1.78x. Reaching 5.0x needs cheaper debt or non-cash interest on the junior tranche.

Step 1How do you build a tranche structure?

A family buying a house takes the cheapest loan the bank offers against it, then, if it needs more, borrows from relatives at a higher rate on the understanding that the bank is repaid first. Tranching fills the cheapest layer first and adds more expensive layers only while the business can still carry the interest. Senior debt at 10.5% is capped at 3.5x by what that market will take; second lienA loan secured on the same assets as the senior loan but repaid only after the senior lenders in an enforcement, so it is priced higher. debt sits behind it at 13%.

Step 2Where does cover stop you?

Start from the floor. At 2.0x, Rs 250 crore of EBITDA can carry at most Rs 125 crore of cash interest. Senior at 3.5x costs Rs 91.9 crore, leaving about Rs 33 crore for second lien, which at 13% is about Rs 255 crore, or 1.0x. Total leverage tops out at about 4.52x. Push to 5.0x with more second lien and interest reaches Rs 140.6 crore, cover 1.78x.

Each tranche adds leverage at a higher price until cover hits 2.0x875Senior term loan3.5x, 10.5%, interest 91.9250Second lien1.0x, 13.0%, interest 32.5500Sponsor equityplug, about 2.0xRs crore, illustrative equityCover check at 4.5xEBITDA250.0Cash interest124.4EBITDA / interest2.01xFloor2.00xAt 5.0x cover falls to 1.78x
Zorvani's proposed structure is Rs 875 crore of senior debt at 3.5x and 10.5% and Rs 250 crore of second lien at 1.0x and 13%, 4.5x in total, with Rs 124.4 crore of interest giving cover of 2.01x against the 2.0x floor.
Cover falls with every turn of second lien; the floor cuts the comps rangecomps 4.5x to 5.0x1.5x2.0x2.5x3.0x3.0x3.5x4.0x4.5x5.0xTotal debt / EBITDA2.0x cover floormax 4.52x1.78x at 5.0x
With senior held at 3.5x, interest cover falls from 2.72x to 1.78x as second lien takes total leverage to 5.0x, crossing the 2.0x floor at 4.52x, so only the bottom of the 4.5x to 5.0x comparable range is available.
Step 3Does the structure also work on cash flow?

Cover is an EBITDA test; check real cash too. After Rs 124.4 crore of interest, about Rs 21.4 crore of tax and Rs 40 crore of capex, free cash flow is about Rs 64 crore, 5.7% of the debt a year. EBITDA less capex covers interest only 1.69x, which is the thinner cushion a chemicals downturn would test. A 15% fall in EBITDA would take cover to about 1.71x, so size the maintenance covenant with that in mind.

Close with how to reach 5.0x if the sponsor insists. Make part of the second lien pay interest in kind, so it accrues rather than drains cash; or accept a smaller senior tranche at a lower margin with tighter covenants. Both buy leverage by shifting risk onto lenders, and the pricing should say so. The honest pitch is 4.5x fully cash-pay, with a PIK option above it for the sponsor to price.

Where candidates lose it

The usual miss is anchoring on the comparable deals and proposing 5.0x because others got it. Comparables tell you what the market has done, not what this company can carry at today's rates.

The second is testing cover on the blended book at a single rate. Each tranche has its own price, and the expensive layer is exactly the one that pushes cover through the floor.

What the interviewer asks next

  • Half the second lien becomes PIK at 14%. What are cash cover and total leverage at 5.0x?
  • Senior pricing tightens to 9.5%. How much more leverage fits under the 2.0x floor?
  • Which maintenance covenant would you set, and at what level?
  • Why might the sponsor prefer a unitranche over senior plus second lien?

Company names and figures are illustrative.