Case 025Fixed income, credit and LDICore

A packaging company's loan has a net leverage covenant of 3.5 times. EBITDA is Rs 80 crore and net debt Rs 240 crore. If EBITDA falls 15%, is the covenant breached, and what equity cure would fix it?

The situation

A private credit fund has lent to Tarkarli Packaging, a maker of corrugated boxes owned by a mid-market sponsor. The loan tests net debt to trailing twelve-month EBITDA every quarter against a maximum of 3.5 times. Today EBITDA is Rs 80 crore and net debt Rs 240 crore.

Paper prices have spiked and a large customer has moved part of its orders to a rival, and management now expects EBITDA to fall 15%. The loan agreement lets the sponsor cure a breach by injecting equity, with limits on how often.

Your task

Is the covenant breached after the fall, what cure would fix it, and how should the lender respond?

Quick check

After a 15% fall in EBITDA, where is Tarkarli's leverage?

Worked solution

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

30-second answerThe answer to give first

Yes, just: leverage rises from 3.0 to 3.53 times, and an equity cure of about Rs 2 crore fixes it. EBITDA falls to Rs 68 crore on unchanged net debt of Rs 240 crore. To get back to 3.5 times, net debt must fall to 3.5 times 68, Rs 238 crore, so the sponsor injects Rs 2 crore to pay debt down. The lender should accept the cure but ask why EBITDA fell, because a 25% fall would need Rs 30 crore.

Step 1How much headroom did 3.0 times really give?

Less than it sounds. The covenant is breached when EBITDA falls to 240 divided by 3.5, Rs 68.6 crore. That is a fall of only 14.3% from Rs 80 crore, so a 3.0 times ratio against a 3.5 times limit is a 14% cushion on earnings, not a comfortable half turn. A bus with 50 seats and 43 passengers looks half empty from the door; it is full after one stop. Always turn a leverage cushion into the percentage fall in EBITDA it can absorb.

A 15% fall in EBITDA uses up all the headroom that 3.0x seemed to offerwithin covenantbreachcovenant 3.5x2.5x3.0x3.5x4.0x4.5xtoday 3.00xEBITDA -15%: 3.53xEBITDA -25%: 4.00xHeadroom at 3.0x: EBITDA can fall 14.3%, to Rs 68.6 crore, before the ratio reaches 3.5x.
Tarkarli's leverage moves from 3.00 times to 3.53 times when EBITDA falls 15%, just past the 3.5 times covenant, because a 3.0 times starting point allowed EBITDA to fall only 14.3%.
Step 2Is the covenant breached, and what cure fixes it?

EBITDA of Rs 80 crore falls 15% to Rs 68 crore, and 240 over 68 is 3.529 times: a breach, by a small margin. An equity cureA right in a loan agreement letting the owner fix a financial covenant breach by injecting new equity, usually counted as reducing debt or, in some agreements, as added EBITDA. reduces net debt: it must fall to 3.5 times Rs 68 crore, Rs 238 crore, so the sponsor puts in Rs 2 crore. Some agreements instead add the cure to EBITDA, in which case Rs 0.57 crore would do; read which one the document allows, because the difference is large when the breach is bigger.

The relationship
Cure=ND−3.5×EBITDAnew=240−3.5×68=2\text{Cure} = \text{ND} - 3.5 \times \text{EBITDA}_{new} = 240 - 3.5 \times 68 = 2
NDnet debt, Rs 240 crore
3.5the covenant maximum
EBITDA_newRs 80 crore less 15%, Rs 68 crore
What it says in wordsThe cure is the net debt above what the covenant allows at the new, lower EBITDA.
Step 3How should the lender respond?

Accept the cure, because Rs 2 crore is small, but treat it as information. The cure grows by Rs 3.5 crore for every further Rs 1 crore of lost EBITDA: at a 25% fall the sponsor would need Rs 30 crore, and at 30% Rs 44 crore. So the lender's questions are about the cause. Paper prices can be passed on with a lag; a lost customer may not come back. Typical cure rights are limited in number and cannot be used in consecutive quarters; check the actual terms. If the fall looks lasting, a reset with a lower covenant path in exchange for amortisation, a higher margin or sponsor support is better negotiated now than after a second breach.

The cure is cheap at the edge and expensive a little further in010203040500%-5%-10%-15%-20%-25%-30%Fall in EBITDA; equity cure needed on the vertical axis, Rs croreheadroom ends at -14.3%at -15%: cure of Rs 2.0 crore-25%: Rs 30 crore
Tarkarli needs no cure until EBITDA falls 14.3%, Rs 2 crore at a 15% fall and Rs 30 crore at a 25% fall, because every rupee of lost EBITDA must be matched by Rs 3.5 of debt repaid.

Where candidates lose it

Candidates read 3.0 times against 3.5 times as plenty of room. The useful number is the EBITDA fall that breaches, here 14.3%, and a 15% fall is ordinary for a cyclical business.

The second miss is computing the cure as if it were added to EBITDA when the agreement reduces debt, or the reverse. The two methods give Rs 2 crore and Rs 0.57 crore here and diverge sharply for bigger breaches, so ask which the document uses.

What the interviewer asks next

  • The sponsor offers to cure with a shareholder loan instead of equity. Should the lender accept it as a cure?
  • How would the answer change if the covenant tested gross debt rather than net debt?
  • What would you want in a covenant reset in return for relaxing the ratio to 4.5 times?

Company names and figures are illustrative.