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  1. 040A company has floating-rate debt of 500 priced at a 5% base rate plus a 4% margin, and EBITDA of 110. The base rate rises by 200 basis points. What happens to interest cover?Credit and PIK mathsWarm upPrivate creditIndian mid-market PE

    Try it first

    Where does EBITDA interest cover go?

    Show the worked solution

    Interest cover falls from 2.44x to 2.0x. The all-in rate is 5% plus 4%, so 9% on 500 is 45 of interest, and 110 / 45 is 2.44x. After a 200 basis point rise the rate is 11%, interest is 55, and 110 / 55 is 2.0x. A two-point rise in the base rate lifts the interest bill by 22% and cuts cash left after interest from 65 to 55.

    Why does a two-point rate rise do so much damage?

    A household with a floating-rate home loan feels every rate rise in the next EMI, while one with a fixed rate does not. On floating-rate debt the borrower carries the rate risk, so a rise in the base rate goes straight into the interest bill. Two points on 500 is 10 more a year, which is 22% more than the 45 being paid today, with no change in how the business is running.

    The base rate rises 2 points; the interest bill rises 22%Today5% base + 4%interest 45left 65cover 2.44x110 / 45Base +200bp7% base + 4%interest 55left 55cover 2.00x110 / 55EBITDA 110 in both rowsExtra interest 500 x 2% = 10, which is 22% more on a bill of 45
    With EBITDA fixed at 110, a 200 basis point rise in the base rate lifts interest on 500 of floating debt from 45 to 55, so cover falls from 2.44x to 2.0x and the cash left after interest falls from 65 to 55.
    The relationship
    Cover=EBITDAD×(b+m)=110500×11%=2.0x\text{Cover} = \frac{EBITDA}{D \times (b + m)} = \frac{110}{500 \times 11\%} = 2.0x
    Dfloating debt, 500
    bthe base rate, now 7%
    mthe lender's margin, 4%
    What it says in wordsInterest cover is EBITDA over the interest bill, and on floating debt the bill moves with the base rate.

    What does a sponsor do about it?

    Most leveraged loans are floating, so sponsors usually hedge part of the debt. An interest rate swap fixes the rate on a portion of the loan, and a cap limits how high it can go in return for an upfront premium. Lenders often require a minimum hedged share in the loan agreement. The trade-off is cost and lost upside: a swap set before rates fall locks the borrower into the higher rate.

    Say what a credit analyst would look at next. EBITDA interest cover ignores capital spending and tax, so cash cover is tighter than 2.0x. A cover covenant set at, say, 2.0x would now be right at its limit, which turns a market move into a negotiation with lenders.

    Where candidates lose it

    The common loss is saying cover is unchanged because EBITDA is unchanged. Candidates forget that the coupon on floating debt resets with the base rate.

    The second loss is adding the 200 basis points to the margin and calling it a 2% rise in interest. The rate goes from 9% to 11%, which is a 22% rise in the bill. Say the percentage change in the bill, not in the rate.

    What the interviewer asks next

    • How much EBITDA growth would restore 2.44x cover after the rate rise?
    • If 60% of the debt is swapped to a fixed 7.5%, what is cover after the rise?
    • Why do lenders often insist on hedging, and who benefits when rates fall?