Case 031Credit and leveraged financeHard

Leveraged finance case: lenders will offer a term loan and unsecured bonds up to stated leverage caps, but the sponsor must keep interest cover at 2.0x. Size each tranche, the cover and the equity cheque.

The situation

A sponsor is buying Zelkora Retail, a chain of home furnishing stores, for Rs 3,000 crore, 8.0x EBITDA of Rs 375 crore. Lenders will provide a senior secured term loan of up to 4.0x EBITDA at 9.5%, and senior unsecured bonds of up to a further 1.5x at 12%.

The sponsor wants as much debt as possible, but its own credit committee insists that EBITDA covers cash interest at least 2.0 times in year 1. Financing fees are 2% of the debt raised and are paid at closing.

Your task

How much of each tranche can be raised, what is the interest cover, and how big is the sponsor's equity cheque?

Quick check

Which constraint sets the total debt?

Worked solution

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

30-second answerThe answer to give first

Rs 1,500 crore of term loan, Rs 375 crore of unsecured bonds, total debt of 5.0x, cover of exactly 2.0x and an equity cheque of Rs 1,162.5 crore. Cover caps interest at Rs 187.5 crore. The term loan uses Rs 142.5 crore of it, leaving Rs 45 crore, enough for Rs 375 crore of 12% bonds rather than the Rs 562.5 crore offered. Coverage binds before leverage.

Step 1Why can't the sponsor simply take everything the lenders offer?

A household can be offered a large home loan by the bank and still decide it cannot afford the monthly payment. Lenders offer debt in turns of EBITDA, but the borrower survives on cash interest, so every debt package has to pass two tests and the tighter one wins. Here the leverage caps allow 5.5x, Rs 2,062.5 crore. The cover test asks a different question: can EBITDA of Rs 375 crore pay the interest twice over? At 5.5x it cannot: interest of Rs 210.0 crore gives cover of 1.79x.

Step 2How do you size each tranche once you know which test binds?

Turn the cover test into an interest budget, then spend it on the cheapest debt first. 2.0x cover means interest can be at most half of EBITDA, Rs 187.5 crore, and senior debt buys more borrowing per rupee of interest than unsecured debt does. At 9.5%, each rupee of annual interest supports Rs 10.53 of term loan; at 12% it supports only Rs 8.33 of bonds. So fill the term loan to its 4.0x cap, Rs 1,500 crore costing Rs 142.5 crore, and spend the remaining Rs 45 crore on bonds: Rs 45 crore divided by 12% is Rs 375 crore, 1.0x EBITDA.

Interest cover falls faster once the 12% unsecured layer starts1.0x2.0x3.0x4.0x5.0x2.0x3.0x4.0x5.0x5.5xTotal debt, turns of EBITDA2.0x minimum cover5.5x lenders'leverage capTerm loan full: 2.63xBinds at 5.0x1.79x5.26x
Zelkora's interest cover falls steadily with debt, steepens at 4.0x where the 12% unsecured layer starts, and hits the 2.0x minimum at 5.0x, before the 5.5x leverage cap where cover would be only 1.79x.
Tranchex EBITDARs croreRateInterest
Senior secured term loan4.0x1,5009.5%142.5
Senior unsecured bonds1.0x37512.0%45.0
Total debt5.0x1,87510.0% blended187.5
Interest cover, EBITDA / interest2.00x
Rs crore. The term loan is filled to its 4.0x cap and the unsecured bonds are sized to use the rest of the Rs 187.5 crore interest budget, giving Rs 1,875 crore of debt at exactly 2.0x cover.
Step 3How big is the equity cheque, and where do the fees go?

Fees are a use of funds, not a reduction in price. Fees of 2% on Rs 1,875 crore of debt are Rs 37.5 crore, so total uses are Rs 3,037.5 crore and the sponsor writes a cheque for Rs 1,162.5 crore, 38.3% of uses. Had the sponsor taken the full 5.5x, the cheque would have been Rs 978.75 crore, smaller by about Rs 184 crore, but its committee would have rejected the deal.

The debt the lenders offer against the debt the cover test allows, Rs croreBuy Zelkora8.0x EBITDA of 3753,037.5Fees 37.5Uses1,500Term loan, 4.0x at 9.5%interest 142.5375Unsecured, 1.0x at 12%interest 45.01,162.5Sponsor equity38.3% of uses-187.5 cut backoffered, not takencover wouldfall below 2.0xSources
Zelkora's Rs 3,037.5 crore of uses is funded by a Rs 1,500 crore term loan, Rs 375 crore of unsecured bonds and Rs 1,162.5 crore of sponsor equity, with Rs 187.5 crore of offered bonds cut back to hold cover at 2.0x.

Close with what would loosen the constraint, because that is the follow-up. At these coupons coverage binds; if rates fell or Zelkora could swap part of the term loan to a lower fixed rate, the same Rs 187.5 crore budget would carry more debt. Equally, a retailer's EBITDA moves with consumer spending, and a 10% fall in year 1 EBITDA would take cover on this package to 1.80x, which is why the committee set the floor in the first place. Note too that cash interestInterest actually paid in cash in the year, as opposed to interest that accrues and is added to the debt, such as a PIK coupon. is what the test counts, so a PIK note could stretch the package, at a higher rate and with more risk to the equity.

Where candidates lose it

The usual loss is stacking both tranches to their caps, quoting 5.5x and a smaller equity cheque, and never testing interest cover. The case gives the cover test precisely so you notice that the 12% layer eats the interest budget fast.

The second is cutting the term loan rather than the bonds. Cheaper debt carries more borrowing per rupee of interest, so you fill the cheapest tranche first and trim the most expensive one.

What the interviewer asks next

  • If the sponsor accepts cover of 1.75x, how much more unsecured debt can it raise?
  • How would a PIK toggle on the bonds change the cover test and the risk to the equity?
  • Zelkora signs leases worth Rs 150 crore a year. How would a lender treat them in leverage and cover?
  • Why might the term loan lenders still object to a large unsecured layer below them?

Company names and figures are illustrative.