Case 052Leveraged finance and LBO financingCore
A sponsor-owned clinic chain wants to borrow more to pay itself a large dividend. Work out what the recap does to leverage and cover, and say whether a lender should agree.
1The situation
Serovan Clinics, owned by a private equity sponsor, earns EBITDA of Rs 300 crore and has Rs 900 crore of debt. The sponsor asks its lenders to increase the loan to Rs 1,500 crore and use the extra Rs 600 crore to pay the sponsor a dividend, a dividend recap. The whole loan would cost 10% a year.
Depreciation and capex are both Rs 60 crore a year, tax is 25% of profit after interest, and working capital is flat. Comparable clinic businesses change hands at about 10x EBITDA.
2Your task
What happens to leverage, interest cover and the time it takes to repay the debt, and would you agree to the recap as a lender?
Quick check
After the recap, what is interest cover (EBITDA over interest)?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
The recap takes leverage from 3.0x to 5.0x and interest cover from 3.3x to 2.0x, and it stretches repayment from about 8 years of free cash flow to about 22. The sponsor takes Rs 600 crore out today; the lenders keep the same business with far less equity beneath them. As a lender, decline 5.0x and offer about 4.0x with a maintenance covenant and a cash sweep.
Step 1What does a dividend recap change, and what does it leave alone?
Picture a family that has paid down half its home loan, then remortgages to the full value and spends the cash on a holiday. The house is the same and the salary is the same; the debt is larger and the family's own stake in the house is smaller. A dividend recapBorrowing new debt to pay a dividend to the owners, so the capital structure changes while the business stays the same. changes nothing about the business and everything about who carries the risk. EBITDA stays at Rs 300 crore. Debt rises by Rs 600 crore and that money leaves the company.
| Rs crore | Today | Counter-offer | Sponsor ask |
|---|---|---|---|
| Debt | 900 | 1,200 | 1,500 |
| Dividend paid | 300 | 600 | |
| Interest at 10% | 90 | 120 | 150 |
| Tax at 25% on (EBITDA less D&A less interest) | 37.5 | 30.0 | 22.5 |
| Free cash flow after capex | 112.5 | 90.0 | 67.5 |
| Debt / EBITDA | 3.0x | 4.0x | 5.0x |
| EBITDA / interest | 3.3x | 2.5x | 2.0x |
| Years of free cash flow to repay debt | 8.0 | 13.3 | 22.2 |
Step 2Where does the risk go?
Value the business at 10x EBITDA, Rs 3,000 crore. Today the debt of Rs 900 crore sits on Rs 2,100 crore of equity, a 70% cushion that must be wiped out before lenders lose a rupee. After the recap the cushion is 50%. The sponsor has converted Rs 600 crore of its cushion into cash, so the lenders now hold the same business with less protection beneath them, and are paid the same 10% for it. Run a downside: EBITDA falls 20% to Rs 240 crore. After the recap leverage is 6.25x, cover is 1.6x and free cash flow is only Rs 22.5 crore. Without the recap the same downside gives 3.75x and 2.7x cover, an uncomfortable year but not a crisis.
Step 3What would you offer instead of a flat no?
Lenders rarely win by refusing outright; the sponsor can refinance elsewhere. Offer a smaller recap at about 4.0x, Rs 1,200 crore of debt and a Rs 300 crore dividend, which keeps cover at 2.5x and free cash flow at Rs 90.0 crore a year. Pair it with a maintenance covenant on leverage set with about 25% EBITDA headroom, a cash sweep of half the excess cash flow until leverage is back under 3.5x, and a ban on further dividends while it is above that level. Ask for a fee or a margin step-up for the extra risk. Say the limit plainly: healthcare cash flows are steady, which is why 4.0x is defensible, but a regulatory change on pricing could cut EBITDA quickly, and 5.0x leaves no room for it.
Where candidates lose it
Candidates compute 5.0x and 2.0x, then say the numbers are fine because the business is stable. The lender's question is not whether the business survives the base case; it is how much cushion is left when EBITDA falls, and the recap removes most of it.
The other miss is forgetting where the Rs 600 crore goes. It leaves the company, so it cannot repay anything later. A new loan for a new plant adds earnings; a recap adds only debt.
What the interviewer asks next
- What if the sponsor offers to fund part of the dividend with a PIK note at the holding company instead?
- How would you set the leverage covenant level for a 4.0x deal?
- Why do lenders often accept recaps late in a credit cycle, and what does that tell you?
Company names and figures are illustrative.