Case 092LBOCore
A lender is shown an LBO of a castings business at 5.0x EBITDA at 10%. In the last downturn EBITDA fell 40% for two years. Does the structure survive a repeat: interest cover, free cash flow after interest and liquidity each year?
1The situation
A sponsor is buying Vetrin Castings, an invented maker of iron castings for tractors and commercial vehicles, and asks your bank to lend 5.0x EBITDA of Rs 100 crore, Rs 500 crore at 10%. Maintenance capex is Rs 30 crore a year and equals depreciation. Tax is 25%, and losses can be carried forward against later profits.
At closing Vetrin will have Rs 5 crore of cash and an undrawn Rs 30 crore revolving credit facility, also at 10%. In the last industry downturn, EBITDA fell 40% and stayed there for two years before recovering.
2Your task
Run five years, normal, two down years and two recovery years, and show interest cover, free cash flow and liquidity. Then say what leverage the business can actually carry.
Quick check
In a down year, with EBITDA at Rs 60 crore, what is free cash flow after interest and capex?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
No: at 5.0x the structure runs out of liquidity in the second down year, about Rs 6.5 crore short. Interest cover falls from 2.0x to about 1.17x and the business burns about Rs 42 crore over two years against Rs 35 crore of cash and revolver. Trough EBITDA covers interest and capex only up to Rs 300 crore of debt, 3.0x; about 4.0x survives with a buffer.
Step 1What does one normal year and one down year look like?
Start with the normal year to see how thin the cushion is. EBITDA of Rs 100 crore less Rs 50 crore of interest, Rs 30 crore of capex and Rs 5 crore of tax leaves Rs 15 crore. In a down year EBITDA falls to Rs 60 crore but interest and maintenance capex do not fall at all, so the same business burns Rs 20 crore. A family with a fixed EMI and fixed school fees feels a pay cut twice over: income drops, and the commitments stay exactly where they were. Interest cover, EBITDA over interest, goes from 2.0x to 1.2x, and cover above 1.0x hides the fact that capex still has to be paid.
Step 2Does Vetrin have enough liquidity to get through two years?
Run the years, because the second is worse than the first. The year 1 shortfall is borrowed on the revolver, so year 2 carries more interest, about Rs 51.5 crore, and burns about Rs 21.5 crore. Two years burn Rs 41.5 crore against Rs 35 crore of cash and revolver, so Vetrin runs out about Rs 6.5 crore short in year 2. Recovery comes one year too late: in year 4 free cash flow is back to about Rs 17.0 crore, sheltered from tax by the losses carried forward. A liquidity runwayHow long a business can keep paying its bills from cash and undrawn credit lines while it is burning cash. that ends before the trough does is a default, however good the recovery.
Step 3What leverage can the business actually carry?
Size the debt from the trough, not from the normal year. At Rs 60 crore of EBITDA, interest can be at most Rs 30 crore after maintenance capex, which supports Rs 300 crore of debt, 3.0x normal EBITDA, with no cash burn at all. A lender comfortable relying on liquidity can go further: at 4.0x the two down years burn about Rs 20.5 crore, inside the Rs 35 crore available with about Rs 14 crore to spare.
Close with the lender's view and its limits. Offer about 4.0x with a larger revolver, or 5.0x only with a sponsor commitment to inject equity if the downturn arrives. Two things could make the picture better than this run: working capital usually releases cash when sales fall, and maintenance capex can be deferred for a year. Both are real, but a lender who counts on them is counting on management cutting into the plant, so treat them as the cushion, not the plan.
Where candidates lose it
The usual miss is testing interest cover alone. At 1.2x it looks survivable, but maintenance capex sits between EBITDA and cash, and the business is burning money while the ratio is still above one.
The second is running only one down year. The shortfall is funded with more debt, so the second year costs more than the first, and liquidity has to last until the recovery, not until the first bad year ends.
What the interviewer asks next
- The downturn lasts three years instead of two. What leverage survives now?
- How would a 50% cash sweep in good years change your answer?
- What covenant would you set so the bank can act before liquidity runs out?
- Would you lend more if half of Vetrin's sales were to the railways on long contracts?
Company names and figures are illustrative.