LBO Debt Question

Good question. Long time member of WSO and thought I should give back a bit to the community by reflecting my thoughts on this.

There's 2 ways you can determine debt capacity.

1. Market Comps approach - i.e. you look at what the market is willing to accept at this point in time. So just like you look at comps when you're trying to value a company, same thing applies here as well. You look at similar HY comps owned by sponsors in same industry segment and see how much leverage they either a) have now ; b) had when they were initially taken public. I'm mentioning a and b because obviously if you're looking at companies that were taking public 3 years ago, current leverage might not be representative of how much leverage you can have (they could have delevered meanwhile). And also look at the leverage of current LBO's coming to the market

2. Fundamental value approach - Just like a DCF is used to determine the "intrinsic or fundamental" value of a company and cash flow is king, debt capacity from a "fundamental perspective" is all about free cash flow and free cash conversion. That is the main factor that determines how much debt you can put on in absolute terms and how many "turns" of EBITDA you can put on the business. Some other factors that could influence this are: growth and type of debt.

Now "very" simplistically and using a "back of the envelope" approach, debt capacity in absolute amount from a fundamental basis is essentially:

(EBITDA - Capex - Unlevered Tax)

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Minimum DSCR (debt service coverage ratio) assumption - This ratio can vary anywhere from 1.1x to 1.8x. Now, how do you define debt service coverage ratio? It's simply (EBITDA-Capex-tax) / debt service (interest + principal). The higher the ratio, the more cushion you have in case something goes wrong, the lower the ratio, the less cushion you have. By same token, companies with super predictable and contracted cash flows (utilities, staples, cable, etc) will be allowed by banks to have a lower ratio and hence lower cash cushion, whilst companies that are inherently cyclical and their cash flows are not predictable (autos, discretionary goods, chemicals, etc) will be required by bank to have a higher DSCR ratio so the lenders can have a bit more cushion if things go wrong. The current state of the leveraged finance market also plays a big role in this - if the markets are on fire, banks will accept a lower DSCR for the same company than they would in a financial crisis obviously,

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(Interest rate (post tax) + principal expressed as a percentage) assumption. Obviously interest rate assumption here is going be a bit circular because interest rate goes up with leverage. Another thing that matters is if you have amortising debt in the structure or not. For example, if you a have bond only structure with no debt amortisation and the principal repayment at maturity, your theoretical debt capacity will be higher than if you do have debt amortisation.

So now here's a quick example:

EBITDA = 100m Unlevered Tax = 25m Capex = 18m UFCF = 57m Cash conversion (UFCF/EBITDA) = 57%

DSCR assumption = 1.3x

Interest post Tax = 5% Principal repayment = 3% Debt service = 8%

Debt Capacity in absolute amount = (57 / 1.3 / 8%) = 548m of debt or 5.5x EBITDA

Debt Capacity in turns of EBITDA (shortcut) = 57% cash conversion / 1.3 / 8% = 5.5x EBITDA

So if you want to totally kill it in the interview you can express all of this in terms of Debt / EBITDA ratio because at the end of the day, an interviewer will be asking you "how much debt can you put on this company" in terms of an EBITDA ratio and not an absolute amount. You then only have to ask him for 1 ratio which is cash conversion and hence avoid all intermediary calcs to get there. You then proceed to explain your rationale for choosing the other 2 important assumptions (DSCR ratio and interest/principal) and if this on the spot 2 min answer doesn't impress him/her don't know what does.

Now some other nuances you should take into account when explaining this:

1. Determining debt capacity is not a question of approach 1 vs. approach 2. You need to take both of them into account and the answer is somewhere probably in the middle. Remember that whilst fundamentally and mathematically speaking, cash flows of a business can sustain say 7x EBITDA of debt, it doesn't mean you can actually put 7x of debt on it. MARKET IS KING. We might be in a recession or a "Risk OFF market" with HY / leverage markets mostly shut let's say. Nobody will lend you 7x (or whatever fundamental cash flows imply), no matter what. Knowing the market appetite for risk and debt is crucial in determining debt capacity. So the market is the most important variable of the 2 here don't forget. That is your "mathematical constraint equivalent in a formula" when calculating debt capacity.

2. You should always cross check the implied Debt/EBITDA ratio you get with the equity cushion of the deal. So if cash flows tell you business can sustain 5.5x debt but the acquisition price is 6x and hence equity cushion is 8% (0.5x), forget about it. Nobody will lend you 5.5x of debt. Minimum equity cushion should be in the 25% / 30% range if not even higher.

3. I've heard people WRONGLY explaining debt capacity simply in terms of equity cushion only. They reason that if most deals in the market have a say 40% equity cushion, you can put 60% of debt on the company. Now let me give you an example how this simplistic answer is wrong. Say PE buys company for 14x EBITDA. This approach would mean debt capacity would be 8.4x. However, NOBODY will put 8.4x of leverage on this if cash conversion is 30%. The reason the company is worth 14x EBITDA might be because it's growing at 7-10% per year. If, however, cash conversion is super high (90%+) because of minimal capex and low taxes AND cash flows are growing at 7-10% a year, you could potentially have a structure that can sustain 8.4x of debt (a lot of this would have to be mezz and deeply subordinated debt with no amortisation). Remember that EBITDA multiple is a product of 3 things: Growth, cash conversion and cost of capital. For debt capacity, cash conversion is crucial, with cost of capital 2nd (determines overall interest rates) and growth 3rd in terms of importance. I'm putting growth last because lenders, (talking about banks holding amortising debt here) don't put that much importance in growth as say a deeply subordinated PIK lender that might depend on the business growing and reaching a certain EV in order to get repaid at maturity. So conclusion here is that equity cushion should serve as a cross-check and not a determinant of debt capacity. Understanding whether "Value" (in terms of turns of EBITDA) is coming from a company growing super fast vs. company having high cash conversion is also crucial in determining what type of debt it can sustain (amortising vs. bullet repayment)

I think this answer and understanding the subtleties I explained, should pretty much answer this question and put you in a good position in any PE interview.