Posted on: June 8th, 2023

$debt-service$

Leveraged buyout transactions rely on large amounts of debt to fund the purchase of a controlling interest in a company. The source of funds includes equity, debt funding as well as any rollover equity or seller note left in the deal. Leveraged buyout financiers use several metrics in sizing their loan envelopes such as loan to value, debt service coverage and leverage ratio. These statistics allow the lender to assess the debt capacity of the leveraged buyout candidate relative to the market and internal credit parameters.

The key measure of finance-ability is the borrower’s ability to service the debt at a comfortable coverage ratio at its current level of earnings. This coverage ratio with EBITDA less capex as the numerator and interest and principal payments as the denominator is sensitive to both microeconomic and macroeconomic variables. The Fed has hiked interest rates a total of 4.75% since the beginning of 2022 when the SOFR rate was a mere .25%. If the spread is 300 bps over SOFR, and the loan is $10 million, the interest expense has increased from $325,000 to $775,000 per annum.

If the Company has $3.33 million in EBITDA, and the $10 million is being repaid over a 5-year term, the debt service ratio reduces from 1.43 times to 1.20 times, a 16% decrease. Companies with stable to growing profit lines can absorb this increase without much inconvenience. However, the combination of increased interest cost and decreased earnings can create a painful debt service coverage whipsaw effect. Given the recessionary clouds on the horizon, leverage buyout lenders are approaching deals more cautiously and selecting those deals that have strong backlogs and earnings visibility.

At higher interest costs, the margin of safety relative to sub-zero debt service coverage is diminished. In this example, it takes on a 16% decrease in EBITDA to arrive at 1 times debt service coverage, which is substandard for leverage buyout lenders. This new debt service coverage math, reflecting high interest rates, will result in a flight to deal quality and more restrained debt loads in middle market leveraged buyouts.

As the Fed decides to ease interest rates, middle market acquisition financing structures will benefit in a number of ways. The underlying values of middle market companies will increase leading to a higher enterprise value and lower loan to value ratios for existing portfolio companies of acquisition financing lenders.

The role of acquisition financing is infrequently elevated above a functional transactional one. When a business needs financing to acquire, they go to the market and source acquisition financing to supplement their equity investment to close the deal. Despite existing in many different forms, acquisition financing is rarely explained in terms of the value it brings to the acquirer.

Acquisition financing underwriting usually focuses on business and financial issues that underpin the stability of cash flow. Providers of acquisition financing usually validate the durability of a company’s competitive advantage and the depth of its resource base. Environmental issues are usually not a major part of the analysis in today’s service and technology-based economy.

The New Debt Service Coverage Math