How Much Debt is Right for Your Deal?

An important decision in any transaction is how it should be financed. This gets down to the mix between debt and equity. The right amount of debt can optimize the capital structure and create value. Conversely, too much debt reduces flexibility, destroys value and can lead to bankruptcy. Frequently, the decision is framed as do you want to eat well (high leverage) or sleep well (low leverage)?

This post focuses upon determining debt capacity and how much debt the deal can support in noninvestment grade buyout transactions. A critical point is that debt capacity is dynamic. It depends on the interplay of the transaction cash flows with market conditions.  Debt capacity fell from its pre-crisis highs, but is currently staging a recovery in the U.S.. This is largely due to increasing investor risk appetite reflecting the low interest rate environment.

   

Business risk reflects on the variability of operating cash flow - usually defined as earnings before interest, taxes, depreciation, and amortization (EBITDA). For example, smaller firms operating in cyclical industries usually have greater EBITDA variance than larger firms in stable industries. Financial risk relates to the level of cash flow to principal and interest debt service requirements coverage and to the equity cushion built into the transaction. Structural risk focuses on creditor priority of claims on the deal’s cash flows and assets as reflected in seniority and security arrangements. It also includes control features like covenants.

A deal’s internal debt capacity, exclusive of asset sales and re financings, is based on two factors. The first is cash flow generation based on EBITDA. The other is structure reflected in cash interest and debt amortization. You can “increase” debt capacity by improving projected EBITDA but beware unrealistic “hockey stick” type assumptions.  You can decrease cash interest payments thru non cash paying payment-in-kind debt and extending out amortization. Market related funded debt (interest bearing debt to EBITDA) and interest coverage (EBITDA to projected interest expense) requirements are determined from the interplay of these factors.   Future posts will focus on how to use special structuring products to expand debt capacity.

In practice debt capacity is heavily influenced by the choice of rating targets for your deal. Ratings are critical to access investors to fund your transaction. They are keys to open market doors needed to fund any deal of size. The process first involves selecting a ratings target -usually in the BB or B range for most buyouts - although during the pre-crisis boom period CCC rated deals could also get funded. The ratings choice impacts risk, cost and market depth considerations. The singe B segment is less deep, subject to abrupt closures and more costly than the BB market segment. Next, the financial requirements of the ratings target and the deal’s financial characteristics are compared. A HIGHLY simplified example illustrates the approach:

               

(A) Ratings choice: BB

            (B) Required interest coverage ratio for BB: 3

            (C) Deal EBITDA: $300

            (D) Blended interest rate for BB rated debt: 10%

            (E) Debt Capacity=(C/B) divided by D= 1000

Of course there many other factors involved, but this illustrates the point. Future posts will further develop and apply debt capacity concepts.

Joe