Case 037Private credit and direct lendingHard

Mahiraj Facility Services reports EBITDA of Rs 80 crore, but the sponsor's adjusted EBITDA is Rs 100 crore after add-backs, so Rs 550 crore of debt is marketed as 5.5x. What is true leverage, and how would you cap the add-backs?

The situation

A sponsor is buying Mahiraj Facility Services, which runs cleaning, security and maintenance contracts for office parks. Reported EBITDA is Rs 80 crore. The sponsor's model adds back Rs 20 crore: Rs 4 crore of one-off costs from closing two loss-making sites, Rs 2 crore of the sponsor's own monitoring fee, Rs 8 crore of run-rate savings from repricing contracts not yet renewed, and Rs 6 crore of synergies from a bolt-on it hopes to buy.

It presents Rs 550 crore of debt as 5.5x adjusted EBITDA of Rs 100 crore, and proposes a maximum leverage covenant of 7.0x, tested on the same adjusted definition with no cap on add-backs.

Your task

Work out true leverage, show how much protection the covenant really gives, and propose a cap on add-backs.

Quick check

On reported EBITDA, how much headroom does the 7.0x covenant leave at closing?

Worked solution

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

30-second answerThe answer to give first

True leverage is 6.9x reported EBITDA, not 5.5x; the add-backs hide 1.4 turns. Under the sponsor's uncapped definition reported EBITDA could fall 27% before the 7.0x covenant trips, and further if new add-backs appear. Cap add-backs at 15% of reported EBITDA and exclude the unsigned bolt-on: EBITDA becomes Rs 92 crore, leverage 6.0x, and the covenant trips after about a 15% fall, a real warning.

Step 1What is an add-back, and why does it matter to a lender?

A job applicant who lists last year's salary plus the bonus he expects, plus the raise he plans to ask for, is not lying, but a landlord would rent to him on the salary. Add-backs restate EBITDA to what the sponsor believes the business will earn, and every rupee added cuts the leverage the lender appears to take. Some are fair: the site closure costs are spent and will not recur, and the sponsor's fee ranks behind the lenders. Others are forecasts. The run-rateA projection of a full year of an effect that has not yet happened for a full year, such as savings from contracts not yet repriced. savings and bolt-on synergies are Rs 14 crore of the Rs 20 crore.

Twenty crore of add-backs turn 6.9x into 5.5x; a 15% cap stops at 9280Reported+4One-off+2Sponsor fee+8Run-rate+6Bolt-on100Adjusted15% cap: 92Rs crore. Axis starts at 60 to show the add-backs. Red: projected or not yet signed.
Reported EBITDA of Rs 80 crore reaches Rs 100 crore after Rs 20 crore of add-backs, Rs 14 crore of them projected or unsigned; a 15% cap stops at Rs 92 crore, so Rs 550 crore of debt is 6.9x reported, 6.0x capped and 5.5x adjusted.
Step 2How much protection does the proposed covenant really give?

The covenant trips when debt exceeds 7.0x EBITDA as defined, so EBITDA must stay above Rs 78.6 crore. On reported numbers Mahiraj is at 6.88x on day one, 1.8% from the line; on the uncapped definition, reported EBITDA can fall 26.8% before anything happens. Worse, nothing stops the sponsor adding fresh run-rate savings each quarter, so the headroom can grow while the business shrinks. A covenant that never trips is not a covenant.

Fall in reported EBITDA before a 7.0x covenant trips, by definitionReported EBITDA1.8%: already at the lineAdd-backs capped at 15%14.6%: a real early warningUncapped adjusted26.8%, and it can grow0%10%20%Debt Rs 550 crore; the covenant trips below Rs 78.6 crore of EBITDA as defined
Before the 7.0x covenant trips, reported EBITDA can fall 1.8% on a reported definition, 14.6% with add-backs capped at 15%, and 26.8% on the sponsor's uncapped definition.
Step 3How would you cap the add-backs?

Three rules, each tied to a line above. Cap total add-backs at 15% of EBITDA before add-backs, allow run-rate savings only for actions taken and only for 12 to 18 months, and exclude synergies from any acquisition not yet completed. The bolt-on's Rs 6 crore falls out; the remaining Rs 14 crore is capped at Rs 12 crore, giving Rs 92 crore of covenant EBITDA and 5.98x leverage. With the covenant at 7.0x on that definition, a fall of about 15% trips it: early enough to bring the sponsor to the table while there is value to protect.

The relationship
Headroom=1−550/7.01.15×80=1−78.692≈14.6%\text{Headroom} = 1 - \frac{550 / 7.0}{1.15 \times 80} = 1 - \frac{78.6}{92} \approx 14.6\%
550 / 7.0the lowest covenant EBITDA that keeps leverage at 7.0x
1.15 x 80reported EBITDA plus add-backs capped at 15% of it
What it says in wordsHeadroom is how far covenant EBITDA can fall before it drops below what the debt needs.

The view to the credit committee: price and structure the loan as 6.9x, not 5.5x. If the sponsor will not accept the cap, cut the debt; on capped EBITDA, Rs 550 crore is about Rs 44 crore more than 5.5x would allow. Ask also for a quality of earnings report from an accountant appointed for the lenders, since the add-backs are the sponsor's claims until someone checks them.

Where candidates lose it

Candidates accept the adjusted figure because it arrives in a model with a definition attached. The first question in private credit is what the business earns now, and every add-back has to earn its place.

The second miss is looking only at leverage at closing. The damage from uncapped add-backs is in the covenant: headroom that expands whenever the sponsor finds a new saving means the lender learns about trouble last.

What the interviewer asks next

  • The sponsor offers a 25% cap instead of 15%. What does that do to covenant headroom?
  • Why do lenders often accept the sponsor's monitoring fee as an add-back?
  • How would you treat the run-rate savings a year later if only half have arrived?
  • What is an equity cure, and would you allow one here?

Company names and figures are illustrative.