Case 001Credit, distressed and capital structureWarm up

Jortan Pharma's loan caps net debt at 3.5x EBITDA. EBITDA falls 20% from Rs 500 crore to Rs 400 crore while net debt stays at Rs 1,600 crore. Is the covenant breached, and how much equity would cure it?

The situation

Jortan Pharma, a generic drug maker, borrowed from a group of banks under a loan with one financial maintenance covenant: net debt must not exceed 3.5x trailing twelve month EBITDA, tested every quarter. Last year EBITDA was Rs 500 crore and net debt Rs 1,600 crore.

A price cut on its largest product takes trailing EBITDA down 20% to Rs 400 crore. Net debt is unchanged at Rs 1,600 crore. The loan lets the shareholders inject equity to cure a breach. A credit fund that owns part of the loan asks you where Jortan stands.

Your task

Is the covenant breached, how much equity cures it, and what should the fund make of the answer?

Quick check

Before calculating: how much equity does the cure take, if the cash repays debt?

Worked solution

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

30-second answerThe answer to give first

Yes: leverage jumps from 3.2x to 4.0x against a 3.5x ceiling, and a Rs 200 crore equity cure fixes it. On Rs 400 crore of EBITDA the covenant allows Rs 1,400 crore of net debt, so Rs 200 crore of new equity used to repay debt restores compliance. The headroom was thin to begin with: EBITDA could fall only 8.6% before the test failed.

Step 1Why does a 20% fall in EBITDA push leverage up by a quarter?

Leverage is a fraction with EBITDA underneath, so it moves against EBITDA, and faster. Picture a home loan of Rs 32 lakh against a salary of Rs 10 lakh: 3.2 years of pay. If the salary drops to Rs 8 lakh, the loan has not changed, but it is now four years of pay. When EBITDA falls 20%, leverage rises 25%, because 1 divided by 0.8 is 1.25. Jortan goes from 1,600 over 500, which is 3.2x, to 1,600 over 400, which is 4.0x.

Jortan's net debt to EBITDA rises from 3.2x to 4.0x when EBITDA falls from Rs 500 crore to Rs 400 crore, breaching the 3.5x ceiling; a Rs 200 crore equity cure that repays debt brings it back to exactly 3.5x.

Step 2How much equity does the cure take, and does it matter how the cure is counted?

Work backwards from the ceiling. At 3.5x, Rs 400 crore of EBITDA supports Rs 1,400 crore of net debt, so Rs 200 crore of new equity that repays debt brings Jortan back to 3.5x. Some loan agreements count the cure differently: the injected cash is added to EBITDA for the test instead of reducing debt, a deemed EBITDA cureA clause that lets equity put in by the owners count as extra EBITDA when the covenant is tested, instead of being used to repay debt.. Then Jortan needs EBITDA of 1,600 over 3.5, about Rs 457 crore, so roughly Rs 57 crore of cash is enough on paper. That version is far cheaper for the owners and far weaker for the lenders, which is why a credit analyst reads the cure clause before anything else.

The relationship

\text{Cure} = ND - 3.5 \times E = 1{,}600 - 3.5 \times 400 = 200 \qquad E_{\min} = \frac{1{,}600}{3.5} = 457.1

ND	net debt, Rs 1,600 crore
E	trailing EBITDA after the price cut, Rs 400 crore
E_min	the lowest EBITDA that passes the test with debt unchanged

What it says in wordsThe cure is the debt above what the ceiling allows; the lowest passing EBITDA is the debt divided by the ceiling.

Step 3How much room did Jortan really have before the price cut?

At 3.2x against 3.5x, Jortan looked 0.3 turns inside the line, and turns sound like a comfortable unit. Convert them into EBITDA and the picture changes. A company at 3.2x against a 3.5x covenant can absorb only a 8.6% fall in EBITDA before it breaches, less than one bad product quarter for a generic drug maker whose prices move with every new competitor. The fund should have been tracking headroom in EBITDA terms all along.

Jortan's 0.3 turns of covenant headroom meant EBITDA could fall only from Rs 500 crore to about Rs 457 crore, a 8.6% drop, before the test failed, and the price cut took EBITDA down 20% to Rs 400 crore.

Step 4What does the credit fund do with the answer?

A breach is the start of a negotiation, not a default in the everyday sense. The lenders can waive it for a fee and a higher interest margin, insist on the cure, or, at the extreme, demand repayment. If a buyer would pay 8x EBITDA for Jortan, the business is worth about Rs 3,200 crore, twice the Rs 1,600 crore of net debt, so for a lender this is a repricing event, not a recovery event. The fund's view turns on one question: is the price cut a one-off, or the first of several as more generic makers enter? If it is the first of several, the cheapest moment to demand the cure and tighter terms is now.

Where candidates lose it

The usual slip is to scale the ratio the wrong way: a 20% fall in EBITDA becomes a 20% rise in leverage, 3.84x, and the cure comes out wrong. Leverage rises by 1 over 0.8, a quarter, and the cure is sized from the ceiling in rupees, not from the gap in turns.

The second is answering breached and stopping. The interviewer wants the next two moves: how the cure is counted, which can change the cheque from Rs 200 crore to under Rs 60 crore, and whether the value of the business still covers the debt.

What the interviewer asks next

EBITDA recovers to Rs 450 crore next quarter with no cure. Is Jortan compliant?
The owners offer Rs 60 crore as a deemed EBITDA cure. Would you accept, and what would you ask for in return?
How does a springing covenant on a revolving credit line change this analysis?

Company names and figures are illustrative.