Case 072Private credit and direct lendingHard

Overnight case study: an aviation services company offers a second lien loan behind a larger first lien. Build base and downside cases, compute value cover at 6x and 4x EBITDA, and give an invest or pass view.

The situation

Harnavi Aviation Services provides ground handling, aircraft maintenance and airport lounges. Its sponsor seeks a Rs 400 crore second lien loan at 13% to refinance a shareholder loan. It ranks behind Rs 800 crore of first lien debt at 9%. EBITDA is Rs 280 crore; depreciation is Rs 50 crore, capex Rs 60 crore and tax 25% of profit after interest.

Aviation services businesses have traded between about 4x and 8x EBITDA over the cycle. A downside case assumes a traffic shock cuts EBITDA by a quarter, to Rs 210 crore. You present to the investment committee tomorrow morning.

Your task

What do leverage, cover and free cash flow look like in each case, how well is the second lien covered by enterprise value at 6x and 4x, and would you invest?

Quick check

At 4x EBITDA of Rs 280 crore, how much of the Rs 400 crore second lien is covered?

Worked solution

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

30-second answerThe answer to give first

Pass at Rs 400 crore: the second lien is fully covered at 6x but only 80% at 4x, and in the downside it is 10% covered at 4x. Total leverage is 4.29x, cover 2.26x, falling to 1.69x if EBITDA drops a quarter. The loan is whole only above 4.29x on today's EBITDA. At Rs 300 crore, whole down to 3.93x, it would be investable at 13% with a leverage covenant.

Step 1How much value sits between the first lien and the second?

Think of a house with two mortgages. The first bank is repaid from the sale before the second sees a rupee, so the second lender's safety is how far the house price can fall before its slice is reached. A second lienA loan secured on the same assets as the first lien but paid only after the first lien is repaid in full. is protected only by the value above the first lien, so its risk turns on the enterprise value multiple more than on this year's cash flow. At 6x of Rs 280 crore, value is Rs 1,680 crore, Rs 880 crore above the first lien, covering the second lien 2.2 times. At 4x, value is Rs 1,120 crore: Rs 320 crore for a Rs 400 crore claim.

The second lien is covered at 6x and only 80% covered at 4xEV 1,6801st lien 8002nd lien 4006x EBITDA of 2802nd lien covered 100%EV 1,1201st lien 800gap 802nd lien 3204x EBITDA of 2802nd lien covered 80%Fully covereddown to4.29xon EBITDA of 280
At 6x EBITDA, Rs 1,680 crore of value covers both liens; at 4x, Rs 1,120 crore covers the Rs 800 crore first lien and only Rs 320 crore of the Rs 400 crore second lien, 80%, and the second lien is whole only above 4.29x.
Step 2What do the base and downside cases show?
Rs croreBaseDownside
EBITDA280210
Interest: 9% on 800, 13% on 400124124
EBITDA / interest2.26x1.69x
Total debt / EBITDA4.29x5.71x
Free cash flow after capex and tax69.517.0
Second lien covered at 6x100%100%
Second lien covered at 4x80%10%
In the base case Harnavi covers its interest 2.26x and generates Rs 70 crore of free cash flow; in the downside cover falls to 1.69x, free cash flow to Rs 17 crore, and at 4x the second lien would be only 10% covered.

The loan pays its interest in both cases; the danger is not a missed coupon but a sale or restructuring at a low multiple in the downside. A traffic shock that cuts EBITDA to Rs 210 crore is also the moment buyers pay 4x rather than 6x, so the two stresses arrive together. In that corner the second lien recovers Rs 40 crore of Rs 400 crore. The 13% coupon pays about 4% a year more than the first lien; over a three-year life that is roughly 12 points of extra income, set against a possible loss of up to 90 points in the bad corner.

How far value can fall before the second lien is hurt25%50%75%100%0%3x4x5x6x7xBase EBITDA 280Downside EBITDA 210100%80%100%10%Enterprise value multiple of EBITDAShare of the second lien covered
On base EBITDA of Rs 280 crore the second lien is fully covered above 4.29x and 80% covered at 4x; on downside EBITDA of Rs 210 crore it needs 5.71x to be whole and is only 10% covered at 4x.
Step 3What do you tell the committee?

Give the view, the reason and the terms that would change it. Pass as offered: at Rs 400 crore the second lien is whole only above 4.29x on today's EBITDA, inside the range this sector has traded through, and the downside pairs lower EBITDA with a lower multiple. Invest at Rs 300 crore, which is whole down to 3.93x, with a total leverage maintenance covenant, call protection of 102 and 101, and a limit on further first lien borrowing so the cushion cannot be filled in from above. Name what would move the view: long contracts with airports and airlines that make EBITDA stickier, or a sponsor willing to put in equity alongside the loan.

Where candidates lose it

Candidates check that interest is covered, see 2.26x, and invest. A second lien rarely fails on its coupon; it fails when value is realised at a low multiple, which is why cover must be measured in enterprise value, not just EBITDA.

The second miss is running the downside on one variable only. In a traffic shock EBITDA and the multiple fall together, so the bad corner is lower EBITDA at a lower multiple.

What the interviewer asks next

  • What coupon would make the Rs 400 crore second lien attractive to you, and how did you get there?
  • The first lien has a Rs 100 crore undrawn revolver ranking ahead of you. Does that change your view?
  • Would you rather hold the second lien or buy the first lien at 97?

Company names and figures are illustrative.