Leveraged finance and the debt stack

Key takeaways

• The debt stack runs from the revolver and senior secured term loans through second lien, high yield bonds and mezzanine to PIK notes; each step down ranks behind the one above and is priced higher.
• Floating rate loans pay SOFR plus a spread; original issue discount and upfront fees raise the lender's yield, conventionally amortised over a three year life for term loans.
• Leverage is debt divided by EBITDA, measured cumulatively through each tranche; coverage is EBITDA divided by cash interest. In the Brennock example total leverage is 5.5x, the blended cost of debt 8.14 percent and cash interest coverage 2.52x.
• Maintenance covenants are tested every quarter; incurrence covenants only when the borrower acts. Most broadly syndicated term loans are covenant lite, with at most a springing test on the revolver.
• Lenders size debt by the tightest of several constraints, typically a leverage cap, a minimum interest coverage and a loan to value limit.

The instruments, from top to bottom

The revolving credit facility (revolver) is a committed line the company can draw, repay and redraw, used for working capital and liquidity. It is usually undrawn or lightly drawn at closing, pays a commitment fee on the undrawn amount and is held by banks, which value it for the relationship. Term loan A is an amortising loan, also bank held, with significant annual repayments and maintenance covenants; it is now uncommon in large sponsor deals. Term loan B is the workhorse of the broadly syndicated market: a senior secured, floating rate loan sold to institutional investors such as collateralised loan obligations (CLOs), with minimal amortisation, typically 1 percent a year, and a bullet at maturity around seven years out.

Private credit funds offer a single alternative, the unitranche: one senior secured loan replacing the first and second lien layers, at one blended spread, sometimes split behind the scenes into first out and last out pieces among lenders. It costs more than a syndicated term loan B but closes faster, with certainty, confidential terms and a small group of lenders to negotiate with later. Second lien loans share the same collateral as the first lien but are paid only after it on enforcement, and are priced well above it.

High yield bonds are fixed rate, usually unsecured or secured senior notes sold to bond investors, with maturities of around eight years, call protection that makes early repayment expensive, and incurrence covenants only. Mezzanine debt is subordinated, privately placed, and often pays part cash, part PIK interest, sometimes with warrants. PIK notes, frequently issued by a holding company above the operating group, pay all interest in kind and rank structurally behind every creditor of the operating companies.

Pricing: SOFR plus a spread, OID and fees

Floating rate loans pay a base rate plus a fixed margin, the spread. Since the retirement of US dollar LIBOR in 2023, the base rate for US leveraged loans is Term SOFR, a forward looking rate derived from the Secured Overnight Financing Rate, usually set for one or three month interest periods. Many loans include a floor, a minimum level for the base rate, which matters only when rates are very low. Because the base rate floats, the borrower's interest bill rises and falls with policy rates, which is why sponsors commonly hedge part of the floating exposure with interest rate swaps or caps.

Lenders are also paid at the outset. Original issue discount (OID) means the loan is funded below par: a loan issued at 99 delivers $99 of cash for every $100 the borrower must repay. Arrangers charge underwriting and arrangement fees for committing to and syndicating the debt. To compare loans, market convention converts OID into an annual spread by spreading it over an assumed life, three years for term loans because most are repaid or refinanced well before maturity. A loan at SOFR + 325 issued at 99 has an all in spread of roughly SOFR + 358.

Bonds are priced differently: a fixed coupon, sold at or near par, with a yield to maturity or yield to worst that accounts for any discount and the call schedule. Their call protection, typically non callable for several years and then callable at declining premiums, is the main reason sponsors pay more for flexible loans than for bonds of similar risk.

Leverage and coverage ratios

Leverage is debt divided by EBITDA. Lenders measure it cumulatively: senior secured leverage counts the first lien debt, secured leverage adds the second lien, total leverage adds everything. A tranche's attachment and detachment points, the leverage at which it starts and stops absorbing loss, tell an investor where it sits in the stack. Net leverage subtracts cash. The EBITDA used is the credit agreement's defined EBITDA, which normally includes add backs for cost savings and synergies expected but not yet realised, so covenant EBITDA can be considerably higher than reported EBITDA.

Coverage measures the ability to pay. Interest coverage is EBITDA divided by cash interest; the fixed charge coverage ratio subtracts capex and cash taxes from EBITDA and divides by cash interest plus scheduled debt repayments. PIK interest is excluded from cash interest because it is not paid, but it compounds the debt, so total leverage rises over time unless EBITDA grows faster.

Covenants: maintenance, incurrence and covenant lite

A maintenance covenant is a financial test the borrower must pass at every test date, usually each quarter, whatever it does: for example, first lien net leverage no higher than 6.0x, or interest coverage no lower than 2.0x. A breach is an event of default, which gives lenders the right to accelerate. In practice a breach leads to a negotiation: an amendment, a waiver, a higher spread and a fee, sometimes a sponsor equity cure. Maintenance covenants give lenders an early seat at the table when performance slips.

An incurrence covenant is tested only when the borrower wants to do something: borrow more, pay a dividend, make an acquisition or an investment. The borrower may take the action only if, pro forma for it, a ratio test is met or the action fits within a permitted basket. An incurrence covenant never causes a default just because EBITDA falls. High yield bonds have always worked this way.

Covenant lite loans, now the large majority of the broadly syndicated term loan B market, have no maintenance covenant for the term loan lenders. Often the only maintenance test is a springing covenant on the revolver, tested only if the revolver is drawn above a threshold, such as 35 or 40 percent of commitments. Private credit unitranche loans more often keep one maintenance covenant, set with a cushion to the sponsor's model, which is part of what direct lenders are paid for. Beyond the headline ratios, lenders now read the baskets, add back definitions and transfer provisions closely, because loose terms have let borrowers move collateral away from lenders or raise new debt ahead of them.

How lenders size the debt

Lenders do not start from the sponsor's request. They size debt from the borrower's ability to carry it and the value beneath it, and take the lowest answer from several tests. The leverage test caps debt at a multiple of EBITDA that the market will accept for the credit, informed by sector, size, cash conversion and what comparable deals have cleared at. The coverage test caps debt so that interest, at the expected rate, leaves a minimum coverage ratio. The loan to value test caps debt as a share of enterprise value so that a meaningful equity cushion sits beneath the loan. Many lenders add a deleveraging test: the business should be able to repay a set share of its debt from free cash flow within the loan's life.

When rates are high the coverage test bites first; when rates are low and multiples high, the leverage and loan to value tests take over. A sponsor that wants more debt than these tests allow can go further down the stack, to second lien, mezzanine or a holding company PIK note, accepting a higher cost for each further turn of leverage.

Templates for this lesson

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• ExcelDirect lending credit memoA sponsor backed unitranche underwritten end to end: base and downside cases, pricing and lender yields, covenant headroom, recovery, debt capacity and a risk rating.Download
• ExcelCovenant compliance trackerEight quarters of leverage, coverage and liquidity tests with capped add backs, step downs, headroom, equity cures, a compliance certificate and a six borrower portfolio monitor.Download