Case 089Leveraged finance and LBO financingWarm up

A sponsor asks for 6x leverage at 11% on a schools business with EBITDA of Rs 100 crore, maintenance capex of Rs 30 crore and cash taxes of Rs 10 crore. Is 6x serviceable, and what is the most you would lend?

The situation

A private equity sponsor is buying Nivrana Schools, which runs a chain of K-12 schools. EBITDA is Rs 100 crore and has grown steadily with enrolment. Keeping the campuses in good repair costs about Rs 30 crore a year of maintenance capex, and cash taxes are about Rs 10 crore a year.

The sponsor asks lenders for Rs 600 crore of debt, 6x EBITDA, at 11% interest, with little amortisation in the early years.

Your task

Does the business generate cash after paying interest at 6x? If not, what is the most you would lend, and why?

Quick check

At 6x, what is left after capex, tax and interest?

Worked solution

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

30-second answerThe answer to give first

No: at 6x the business is Rs 6 crore short every year after interest, so the loan would be funding its own interest. Rs 100 crore of EBITDA leaves Rs 60 crore after capex and tax, against Rs 66 crore of interest. Free cash flow only breaks even at 5.45x. At 4.5x it is Rs 10.5 crore, but a 15% dip in EBITDA wipes that out, so the most I would lend is about 4.0x, Rs 400 crore.

Step 1What should EBITDA be compared with?

Not with interest alone. EBITDA is before the money the business must spend to stay open and before tax. The test of whether debt is serviceable is free cash flow after interest: EBITDA less maintenance capex, less cash tax, less interest. A household earning Rs 1 lakh a month cannot borrow as if the whole lakh were free: rent and groceries come first, and only what is left can service a loan. For Nivrana, Rs 30 crore of upkeep and Rs 10 crore of tax come first, leaving Rs 60 crore.

Step 2Is 6x serviceable?

At 6x the debt is Rs 600 crore and interest at 11% is Rs 66 crore. That is Rs 6 crore more than the Rs 60 crore available, so free cash flow is negative before any repayment. The loan can only be serviced by drawing on a revolver or cash reserves, which means the debt grows every year it is outstanding. Cash after capex and tax covers interest only 0.91 times, below one.

Free cash flow after interest at 6x and at 4.5x, Rs crore6.0x: debt Rs 600 crore at 11%100EBITDA-30.0Capex-10.0Tax-66.0Interest-6.0FCF4.5x: debt Rs 450 crore at 11%100EBITDA-30.0Capex-10.0Tax-49.5Interest+10.5FCF
From Rs 100 crore of EBITDA, capex of 30, tax of 10 and interest of 66 at 6x leave free cash flow of minus Rs 6 crore, while at 4.5x interest of Rs 49.5 crore leaves plus Rs 10.5 crore.
The relationship
Dmax⁡=100−30−100.11=545  crore=5.45×EBITDAD_{\max} = \frac{100 - 30 - 10}{0.11} = 545 \;\text{crore} = 5.45\times \text{EBITDA}
100EBITDA, Rs crore
30maintenance capex
10cash taxes
0.11interest rate
What it says in wordsAbove about Rs 545 crore of debt, interest alone uses up every rupee the business generates, with nothing left to repay principal.
Step 3What is the most you would lend?

Less than the break-even, because a lender needs room for a bad year and for repayment. At 4.5x, Rs 450 crore, free cash flow is Rs 10.5 crore, but a 15% fall in EBITDA takes it to minus Rs 4.5 crore; at 4.0x, Rs 400 crore, the same fall still leaves Rs 1 crore. So the most I would lend is about 4.0x, with free cash flow of Rs 16 crore in the base case going to repay debt. Schools have steady fee income, which is why 4x is possible at all; a more cyclical business would support less.

Say the limitation. Cash taxes would fall a little at higher leverage, because interest is deductible, which narrows the gap at 6x but does not close it. And maintenance capex is an estimate a sponsor has every reason to trim; a lender should check it against what the campuses have actually needed in past years before trusting the Rs 30 crore.

Where candidates lose it

Candidates compare EBITDA of Rs 100 crore with interest of Rs 66 crore, see 1.5x cover and approve. EBITDA is not cash available for interest; capex and tax come first.

The second is stopping at the break-even of about 5.5x. A loan sized to break even has no room for a weak year and never gets repaid.

What the interviewer asks next

  • How much EBITDA growth would make 6x serviceable within three years?
  • The sponsor offers a PIK tranche for the extra 2x. Does that solve the problem?
  • What covenant would you set on this loan, and at what level?

Company names and figures are illustrative.