How Do You Estimate a Company's Debt Capacity?

fomc's picture
Rank: Senior Baboon | 212

very simple question. How do you estimate how much debt you can put on a company for acquisition purposes? Why can you put 3.5x senior debt on one transactions and 5x on another? Obv industry and volatility of earnings is gonna play a major role, but mathematically, whats the formula to determining the debt capacity?

Qualitative Debt Capacity Analysis

The amount of debt that a company can obtain depends on a variety of different factors. Some of these factors include:

  • Current capital structure and types of debt
  • EBITDA and ability to handle interest expense
  • Size of the company
  • Industry (stable or cyclical)
  • Current credit rating
  • State of the credit markets

Our users explain below.

workerbee - Investment Banking Analyst:

Its debt capacity is dynamic and based on a variety of factors including capital structure, type of debt, covenants, etc, but ultimately depended on its ability to handle the interest expense. So FCF = after-tax interest expense.

XPJ:

Things to also take into consideration: size of company and industry (ie stable vs cyclical CF), credit, and more importantly, how much debt the company currently has. In the middle market, it's tough to get more than 5x debt/ebitda, so if the company doesn't have any debt, obviously, you can lever it up more in a lbo/acquisition.

love.live.life - Investment Banking Analyst:

A lot of it also has to do with how much the banks are willing to lend. This comes as a result of many company specific factors, including those that were mentioned in the other posts, but is also dependent on the state of the economy at the time. Deals were a lot more levered pre-crisis than now because banks are not lending as much. When they do lend, they put in place a lot more covenants to prevent excessive leverage.

feenans - Investment Banking Analyst:

It's also useful to think of debt capacity in terms of credit rating. Even if the market allows you to take on a lot of debt, the company wouldn't want to be rated at near default (in most cases).

What I mean is, the question is not "What is the maximum debt capacity of this company?", but "What is the maximum debt load required to remain investment grade/above AA/etc".

Quantitative Debt Capacity Calculation

From a quantitative perspective this can be done several ways. However, at sell side firms when doing quick analysis about how much debt a company can take on, banks will look at the Debt / EBITDA multiple. EBITDA is a proxy for cash flow and the ability of a company to pay off its debts and interest expenses with the cash flows from the operations of the business.

Using a Net Debt / EBITDA multiple, a bank can get a quick sense for how much debt a company could take on and still be in line with the average leverage levels of the peer set or industry. You can also use this method to check for covenant compliance if a firm has a covenant that specifies a Debt / EBITDA multiple or if a credit rating agency has promised a downgrade if the company falls below a certain debt / EBTIDA level.

You can see the process below.

The bank looks at the industry average Debt to EBITDA metric and multiplies it by the company's EBITDA to find the total capacity for debt and removes the current debt to find the additional capacity that the company could handle.

A similar approach can be applied using the interest coverage ratio.

While this is a quick method, it is important to note that debt focused groups such as DCM or Leveraged Finance will have more precise ways of deciding how much debt the company can take on.

Read More About Net Debt on WSO

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Comments (50)

Mar 30, 2011

Its debt capacity is dynamic and based on a variety of factors including capital structure, type of debt, covenants, etc, but ultimately depended on its ability to handle the interest expense. So FCF = after-tax interest expense.

Mar 30, 2011

In addition to Workerbee's comments, things to also take into consideration: size of company and industry (ie stable vs cyclical CF), credit, and more importantly, how much debt the company currently has. In the middle market, it's tough to get more than 5x debt/ebitda, so if the company doesn't have any debt, obviously, you can lever it up more in a lbo/acquisition.

    • 1
Mar 30, 2011

very simple question

Not really...

Mar 30, 2011

A lot of it also has to do with how much the banks are willing to lend. This comes as a result of many company specific factors, including those that were mentioned in the other posts, but is also dependent on the state of the economy at the time. Deals were a lot more levered pre-crisis than now because banks are not lending as much. When they do lend, they put in place a lot more covenants to prevent excessive leverage.

XPJ:

and more importantly, how much debt the company currently has. In the middle market, it's tough to get more than 5x debt/ebitda, so if the company doesn't have any debt, obviously, you can lever it up more in a lbo/acquisition.

I don't think the amount of debt a company has before an LBO plays a role in how much debt a sponsor can get for an LBO. The existing debt is refinanced in LBO transactions (i.e. existing debt holders are paid back early), so it doesn't really matter. Someone who works in a senior role in PE once told me "We don't care about their capital structure, because we're going to blow it up anyway," so having less debt doesn't make a company more attractive to a sponsor.

Aug 30, 2013

Of course the amount of debt a company has before the takeover plays role. You need to allocate a portion of the new debt you raise in order to refinance. Companies that strategically position themselves to not be a target of an LBO deliberately take steps to lever up and keep less cash on hand. Significantly increasing net debt can be a deterrent to buy out shops.

Mar 30, 2011

It's also useful to think of debt capacity in terms of credit rating. Even if the market allows you to take on a lot of debt, the company wouldn't want to be rated at near default (in most cases).
What I mean is, the question is not "What is the maximum debt capacity of this company?", but "What is the maximum debt load required to remain investment grade/above AA/etc".
To estimate ratings with pro-forma debt load, look at the relevant metrics for the peer group (size and leverage usually explain most variation), and link the ratings to these metrics. For example, you can use a regression
Credit Rating = B1Revenue + B2Debt/EBITDA, and solve for the maximum Debt/EBITDA multiple given a credit rating constraint.
...Just another way to look at it.
EDIT: To avoid confusion, the above approach is not really relevant in the context of an LBO, but you can use to estimate capacity for an industry client looking to finance an acquisition with debt.

    • 1
Mar 30, 2011
feenans:

It's also useful to think of debt capacity in terms of credit rating....
For example, you can use a regression
Credit Rating = B1Revenue + B2Debt/EBITDA, and solve for the maximum Debt/EBITDA multiple given a credit rating constraint.
...Just another way to look at it.
EDIT: To avoid confusion, the above approach is not really relevant in the context of an LBO, but you can use to estimate capacity for an industry client looking to finance an acquisition with debt.

LMFAO hahaah

if you went to anyone any distrdesk/lev fin/mezz/buyout shop w your revolutionary formula you would likely get roundhouse kicked in the face. That's good you can try that kind of sht anonymously thru a forum.

Mar 31, 2011
DurbanDiMangus:
feenans:

It's also useful to think of debt capacity in terms of credit rating....
For example, you can use a regression
Credit Rating = B1Revenue + B2Debt/EBITDA, and solve for the maximum Debt/EBITDA multiple given a credit rating constraint.
...Just another way to look at it.
EDIT: To avoid confusion, the above approach is not really relevant in the context of an LBO, but you can use to estimate capacity for an industry client looking to finance an acquisition with debt.

LMFAO hahaah

if you went to anyone any distrdesk/lev fin/mezz/buyout shop w your revolutionary formula you would likely get roundhouse kicked in the face. That's good you can try that kind of sht anonymously thru a forum.

What part of "To avoid confusion, the above approach is not really relevant in the context of an LBO, but you can use it to estimate capacity for an industry client looking to finance an acquisition with debt" did you not understand? Obviously this is not the correct approach for sponsors/mezz funds, but other posters touched on that perspective so I was adding alternative considerations. What made you think this is "revolutionary"? Rating considerations of this kind are pretty standard, actually. The regression I made up is clearly a simplified example.
WTF is your problem?

Mar 30, 2011

Typically, you want low volatility / low cyclicality / low seasonality of cash flows, and even in the downside case, you want interest coverage of 2X.

Also, debt comps allow you to see how similar companies are levered; competitors provide a relevant reference point (assuming they're not in or approaching chapter 11).

Mar 30, 2011

My threads.

Mar 30, 2011

All above thumbs up
Also try to relate lev capacity to your long term model..build a downside case w bearish drivers for a downside FCF forecast, and see how much you can stress operating assumptions before you trip covs and/or miss int pmts and/or miss maturities. Qualitatively understand likelihood of such a scenario given your rev model and cost structure.

90% sure you're going for a mezz fund interview

Mar 30, 2011
DurbanDiMangus:

90% sure you're going for a mezz fund interview

I will be very soon, so this was helpful. Cheers, folks.

Mar 31, 2011

What exactly is a covenant / cov-lite?

Mar 30, 2011

there's a DB pdf on the web that explains lbo's and give some numbers (debt multiples) ... use google ...

Mar 30, 2011
kraken:

there's a DB pdf on the web that explains lbo's and give some numbers (debt multiples) ... use google ...

Talking about this?

http://www.nkaramouzis.gr/files/7teac/DB%20LBO%20A...

Mar 30, 2011

Another point to consider which has not been mentioned so far is the enterprise valuation

Mar 31, 2011

Assuming that this is for buyout purposes you want to look at several factors:

  1. Size and quality of collateral: Most senior lenders will lend against certain types of collaterals vis-a-vis asset-backed loans, be it account receivables, inventory, real estate, plant and equipment, financial assets. The rule is the more liquid and easily seizable an asset is, the less discount the lender will apply against it. In some transactions certain mezz funds or hedge funds are willing to lend against intangible assets, such as rights to a portfolio of patents or intellectual property (Marvel famously raised a couple of billions by borrowing from Wall Street by pledging rights to its comic book characters). In cases where there is a financing gap, the business owner (for middle market transactions) will need to step in with a personal guarantee, in which case their personal assets or equity in the business will need to be pledged.
  2. Cashflow: For companies with a compelling growth story, be it promising technology or sizable addressable market with few competitors, certain mezz funds are willing to lend against cashflow. I am not sure about the prevailing rates currently but it's usually a multiple of the EBITDA with warrants to capture potential upside.
Apr 3, 2011

hire a bank to do it while you're on the golf course

Aug 30, 2013

Sweet answer man. Thanks for repeating everyone else's in a thread that is over 750 days old.

Aug 31, 2013

Correcting dumb comments never gets old.

    • 1
Aug 31, 2013

A company's debt capacity is as much as the investment bank thinks it can get it to issue.

Aug 31, 2013

You can build a sculpted amortization model. Basically you set a given maturity at which your debt should amount to zero and then basically you add back the amount available for sweep to build up to the amount a company can swallow. It is a very circular model, but that's just the way it works.

You have to make assumptions for interest rate, amortization and % cash flow sweep. Can't send you an actual model. Sorry.

Aug 31, 2013

link it to a rating grid to see how much debt they could raise without impacting their current rating.

Aug 31, 2013

Does someone have the Excel sheet template(for debt capacity analysis) that is included in the Enrique Arzac's book ?

http://www.Amazon.com/Valuation-Mergers-Buyouts-Restructuring-Finance/dp/0470128895/ref=sr_1_4?s=books&ie=UTF8&qid=1293331680&sr=1-4#reader_0470128895

Aug 31, 2013

Well under 5x for an LBO??? Looking at the LBOs this year it seems the average is around 5x.

Aug 31, 2013

Thank you Rahul. That was helpful.

Aug 31, 2013

Different from optimum cap structure as mentioned and typically this would be linked to a ratings grid, e.g. debt capacity of $xm based on target mid BBB+ rating. Credit metrics vary between S&P / Moody's but generally include leverage (i.e. debt / EBITDA), coverage (e.g. EBITDA / interest) and cash flow (e.g. FFO / debt), amongst others. Example of where this is relevant are IPO debt capacity to calculate how much cash you can take out / primary proceeds you need pre-IPO at a certain target credit rating; acquisition debt capacity to calculate what % of an acquisition you can finance with cash/debt vs. shares and maintain a target credit rating, etc.

In LBO context, average LBO debt multiple was indeed 4.7x in 2010 vs. 4.0x in 2009 and 4.9x in 2008 (for issuers with EBITDA > $50m). We're basically back to 2004 leverage (average of 4.8x). Obviously also have to include minimum equity cheque size (average was c. 40% in 2010).

Very much looking forward to another uptick in M&A in 2011 - definately a good environment with attractive financing conditions, lower volatility/price stability, lots of cash on B/S, and limited organic growth opp's for most companies in this environment.

Aug 31, 2013

in simple terms, debt capacity is influenced by interest rates and risk perception by the banks (liquidity risk )

Aug 31, 2013

You specifically mentioned LBOs. I and every other banker in this thread can pull up every LBO deal done in 2010 and we all are coming up with around 5x.

Aug 31, 2013

Just wondering, specifically for LBOs are there any good sites to get information on the usual Debt / Ebitda coverage ratios?

Aug 31, 2013

There are plenty. Most of the publications that produce monthly or quarterly M&A publications (with data) will have them (Thomson, Pitchbook, GF Data, CapIQ LCD, etc.).

Aug 31, 2013

x2

Feb 8, 2018

Beside stuffs mentioned above, you can build a model and select a leverage level which maximizes the levered equity return which also incorporates the stress test on most important variables. Let's say you can stress test revenue growth and see how much it affects the ability to handle given debt amount. Then after considering revenue growth or revenue level assumption you can maximize the amount of debt. Everything depends on the situation. So stress test.

Feb 8, 2018

I'm not in LevFin but have worked on many high yield trades....this is not an exhaustive list but to start, industry and credit rating are big factors in determining max leverage (highly cyclical industries will generally support less leverage than others). You'll also need to understand what the cash flow profile of the company is, as you'll typically want sufficient free cash flow to pay down 50% of the debt (or more) within 7 years, as a general rule of thumb. Companies with high Free Cash Flow generally can support higher initially leverage. Most industries underwrite debt off of LTM EBITDA, but others may give you credit for future (for example high growth industries, or industries where a significant percentage of future revenues are booked).

For pricing, the seniority of the debt (sr vs subordinate, secured vs unsecured), the covenants, the call premiums and breakage fees all will impact pricing. Sr debt is cheaper than jr debt, covenant heavy debt is cheaper than covenant light, etc...You'll also want to know general market conditions, including recent debt comps, the market impacting syndication (i.e. are there a number of similar issuances in market or is this something investors are thirst for), and the general yield curve.

Feb 8, 2018

^^^pretty much this.

as general leverage guidelines, anything over 4.0x leverage on a public company is a lot. 3.0x-4.0x on a PF LTM EBITDA + synergy basis is probably the sweet spot for transformative m&a deals. for a buyout, depends on the industry but 5.0x-7.0x on a pro forma basis is common for a company with decent margins.

pricing is heavily dependent on market environment but you can usually get a sense for it based on where recent deals in the industry have priced. ballpark numbers right now are probably: revolvers at L+100-200, TLA at L+200-350, TLB at L+350-500, unsecured notes at 7.0%-9.0%

Feb 8, 2018
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