Case 057Leveraged finance and LBO financingCore
A sponsor financing a buyout can use a floating term loan B or a fixed high yield bond with three years of call protection. Compare cost when rates rise and fall, and the cost of exiting in year 2.
1The situation
A sponsor is buying Ishanvi Specialty Glass and needs Rs 2,000 crore of debt. Option one is a term loan B at a floating benchmark, 6.5% today, plus 3.75%, so 10.25% now, with 1% of the original amount repaid each year and prepayable at par at any time. Option two is a high yield bond at 10.5% fixed, non-call for three years, then callable at 105.25, par plus half the coupon.
Before year 3 the bond can be repaid only through a make-whole: the issuer pays the present value of the coupons to the first call date plus the first call price, discounted at the government yield, 6.8% today, plus 0.50%. The sponsor thinks it may sell or refinance Ishanvi at the end of year 2. Test rates moving 1.5% either way from the start, with government yields moving by the same amount.
2Your task
What does each option cost a year in each rate case, what does exiting at the end of year 2 cost, and why might a sponsor still choose the bond?
Quick check
Rates fall 1.5% and the sponsor wants to refinance at the end of year 2. What happens to the bond's exit cost?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
On today's rates the loan is slightly cheaper, Rs 205 crore a year against Rs 210 crore, and far cheaper to exit early: repaying the bond at the end of year 2 costs a make-whole of about Rs 158 crore. If rates rise 1.5% the loan costs Rs 235 crore a year and the fixed bond wins on running cost. A sponsor chooses the bond to lock the rate and escape maintenance covenants, and pays for it in exit cost.
Step 1What is each option really selling?
Think of renting a flat on a floating rent that follows the market, with one month's notice, against a fixed rent for three years with a penalty for leaving early. The term loan BA syndicated loan sold mostly to institutional investors, usually floating rate, with small yearly repayments and prepayable at or near par. sells flexibility and leaves the rate risk with you; the bond sells rate certainty and charges you for leaving. Ishanvi's choice turns on two unknowns: where rates go, and when the sponsor wants out.
| Rs crore | Rates down 1.5% | Base | Rates up 1.5% |
|---|---|---|---|
| Term loan B rate | 8.75% | 10.25% | 11.75% |
| Term loan B interest, year 1 | 175 | 205 | 235 |
| Bond interest, every year | 210 | 210 | 210 |
| Make-whole price at end of year 2 | 109.40 | 107.88 | 106.39 |
| Make-whole premium paid | 188.1 | 157.5 | 127.8 |
| Two years plus exit: term loan B | 348.2 | 407.9 | 467.6 |
| Two years plus exit: bond | 608.1 | 577.5 | 547.8 |
Step 2How is the make-whole worked out?
At the end of year 2 the bond has one coupon of 10.5 left before the first call date, when it could be repaid at 105.25. A make-wholeA redemption price equal to the present value of the payments the investor gives up, discounted at a government yield plus a small spread, so the investor is compensated for early repayment. pays the present value of both today. In the base case that is 115.75 divided by 1.073, which is 107.88, so the premium is about 7.9% of Rs 2,000 crore, Rs 158 crore. If rates have fallen 1.5% the discount rate is 5.8% and the price is 109.40. The protection costs most exactly when a refinancing would save most.
Step 3So why would a sponsor ever choose the bond?
Three reasons, and interviewers want all three. First, rate certainty: a sponsor that plans to hold for five years and fears rising rates buys a known cost. Second, covenants: bonds usually carry incurrence covenants only, tested when the company does something such as borrowing more, while bank-style loans may carry maintenance covenants tested every quarter, which can trip in a bad year even if every payment is made. Third, maturity and investor base: bonds usually run longer, with no yearly amortisation, and draw on a different pool of investors. The limit is the one in the numbers: if the sponsor's own plan is to exit in two years, the bond's call protection turns a small running difference into a large exit bill. The view for Ishanvi: term loan B, unless the sponsor expects to hold beyond year 3 and wants protection from rising rates.
Where candidates lose it
Candidates compare 10.25% with 10.5% and call the loan cheaper, full stop. That ignores both the rate risk the loan leaves with the sponsor and the call protection the bond imposes.
The subtler loss is getting the make-whole's direction wrong. It is a present value, so it rises when rates fall, which is exactly when the sponsor would want to refinance.
What the interviewer asks next
- How would an interest rate cap on the term loan change the comparison?
- What is a likely call schedule after year 3 for a bond that is non-call for three years, and why?
- Why do term loan B lenders often ask for a six-month soft call at 101?
Asked at Lazard, Generalist, Amsterdam, 2025 (Wall Street Oasis): Why would a sponsor prefer to take on high yield debt to finance an LBO over bank debt?
Company names and figures are illustrative.