Covenant Step-Down: a Worked Example

Debt for an acquisition or a buyout is usually sized on a forecast that has the business paying it down. At completion leverage is high, and the lender's case is that it will fall: earnings grow, cash repays the term loan, and in three or four years the business carries debt it could refinance without difficulty. A covenant fixed at the completion level would not test that case. A business could miss its forecast every year and still not come near a line drawn for day one.

The step-down closes that gap. Each test date gets its own level, derived from the forecast for that date, so the covenant keeps asking the question the credit paper answered: is the business on the path the debt was lent on? Step-downs belong mostly to lending sized on a plan to reduce debt, such as acquisitions, buyouts and recapitalisations. A bank facility for an established business with stable borrowings more often carries one level for its whole term.

The usual starting point is a base case: a forecast the lender and the borrower agree before signing, typically more cautious than the owner's own plan. For each test date the lender takes forecast debt and forecast EBITDA and allows a cushion, the share by which EBITDA could fall short of the base case before the covenant is breached. The cushion is negotiated deal by deal, and in competitive sponsor-backed markets it is widely reported to have widened over the past decade.

Many agreements add a flatline, a level below which the steps stop, often near the leverage the lender is content to hold to maturity. Cover covenants step the other way, with the minimum rising over time. And because the steps fall on test dates, a step that lands in a seasonally weak quarter bites harder than one that lands at the peak, so the schedule is read beside the test calendar.

A pest-control business bought by a private equity fund, constructed for this page like every figure in it, completes with debt of US$42m against EBITDA of US$12.0m, 3.5 times. The base case repays US$2m a year and grows EBITDA by 10% a year. The lender sets annual leverage levels with a 30% cushion on the base case, rounds each to the nearest quarter turn, and flattens them from year three. These terms are the example's, not a market norm.

Nothing went wrong in this business. Its earnings held, its repayments were met, and its leverage fell every year. Yet the share of EBITDA it could lose before a breach fell from 22% to 8% in three years, because the covenant moved towards the base case faster than repayments alone moved the business. A 9% fall in EBITDA would breach in year three; the same fall in year one would not have come close. In year four the flatline stops the covenant falling while repayments continue, and headroom widens for the first time. Without it, the base case would have set 2.75 times, and the business would be in breach at 2.83.

A margin step-down is a different clause with a similar name. The interest margin falls as leverage falls, so it rewards the same deleveraging the covenant step-down demands. Both usually run off the leverage figure in the compliance certificate, which means a single certificate can improve the price and narrow the headroom at once, and a borrower reading only the pricing grid can miss the second effect.

Nor is a step-down the same as headroom, though it governs it. Headroom is read at each test from actual figures; the step-down fixes where the line will be next. A lender monitoring the file therefore projects headroom against the next step rather than the current one, and that forward reading is usually where a breach in a stepping structure first shows.

DEFINED IN ONE PARAGRAPH → · THE TEST DATE → · LOAN COVENANTS, EXPLAINED →

The schedule is argued before signing. The borrower's case is that the steps should follow its own plan, or not exist; the lender's is that they should follow the base case it lent on. Three points carry most of the negotiation: the cushion, the timing of the first step, since a step in the first year leaves little room for integration costs after an acquisition, and the flatline. A borrower with a credible plan to repay debt gives up less by accepting steps than one whose plan rests on growth it has not yet shown.

Once signed, the steps decide when the conversations happen. A business trading flat reaches the line on the calendar rather than on bad news, and a lender projecting headroom forward can see it a year out. The usual answers are an equity cure, a prepayment from cash or a negotiated reset, and the purpose of the step-down is that the conversation starts while there is still time for one of them.

COVENANT RESET → · DEBT TO EBITDA →