First-Lien Leverage: a Worked Example

When a secured business is sold up, what it fetches is paid out in order of rank. Lenders holding first-ranking security over the same assets share the proceeds, usually pro rata to what each is owed, before anything reaches a second-lien lender, a mezzanine lender or the shareholders. To a first-lien lender, the debt behind it is a cushion. It was lent against the same earnings, but it absorbs the first fall in value. Total leverage says how hard the business works to carry all its debt. First-lien leverage says how much of the business's value the top of the structure must share before anyone behind it is paid.

The ratio is mostly a leveraged-finance measure, written into documents for buyouts and other structures with more than one layer of secured debt. In much mid-market bank lending in New Zealand and Australia a single bank or a club holds a general security agreement, and first-ranking debt is close to everything the business has borrowed. The measure starts to matter there when a second-ranking lender, a vendor loan or a fund's subordinated loan joins the structure. Documents in all three markets also use the names senior leverage and senior secured leverage, and those can mean different things.

Every line hides a drafting choice. Covenant definitions commonly count only the drawn part of the revolving facility, so a lender also reads the figure with the revolver fully drawn, because a business in trouble draws its line. Letters of credit and guarantees issued under the revolver may be in or out. Cash may be netted in full, netted up to a cap, or not netted at all. The EBITDA is usually for the last twelve months and may carry pro forma adjustments for acquisitions and promised savings, each of which lowers the ratio without changing the debt. And some claims that would share the first-ranking security in an enforcement, such as secured hedging close-out amounts, may sit outside the covenant's definition of debt.

A packaging manufacturer owned by a private equity fund, constructed for this page like every figure on it, earns EBITDA of US$40m. Its operating company owes US$130m on a first-lien term loan and has drawn US$10m of a US$30m revolving facility, both secured on the same assets, and owes US$45m on a second-lien loan. Its holding company owes a further US$25m to an investor, outside the operating group's security. It holds US$12m of cash.

If the first-lien covenant were set at 4.0 times net, a level chosen for the example, the business would have 0.8 of a turn of headroom. The lender's own reading goes further: EBITDA falls by a quarter and the revolver is drawn to its limit.

The covenant figure of 3.2 times describes the business on an ordinary day. The stressed figure describes the claim the first-lien lenders would share the value with. In this case they are repaid in full: the value falls short of the total debt, but the shortfall lands on the US$45m of second-lien debt behind them, whose lender recovers less than half, and on the holding company's investor, who recovers nothing. The 6.0 multiple is the example's assumption, not a market value.

Total leverage counts every borrowing, whatever its rank, and it is the figure an equity investor or a rating analyst starts from, because all of it must be serviced from the same cash. First-lien leverage measures position rather than burden. It can stay flat while the business borrows more behind it, and a first-lien lender may accept that, provided the junior debt is genuinely subordinated and its interest does not drain the cash the senior debt depends on. Senior secured leverage sits between the two and in many documents includes second-lien debt, which is secured on the same assets but ranks behind.

Rank can also come from structure rather than contract. The US$25m owed by the holding company in the example ranks behind every creditor of the operating company, because it can be repaid only from what the operating company pays up to its parent. That is structural subordination. Between lenders at the same company, it is the intercreditor agreement that makes the agreed ranking hold.

DEFINED IN ONE PARAGRAPH → · DEBT TO EBITDA, READ BY A LENDER → · THE RECOVERY WATERFALL →

First, the covenant. In covenant-lite deals with a term loan B, the only maintenance test is often a first-lien leverage ratio that protects the revolving lenders and springs into effect only when the revolver is drawn beyond a stated share of its commitments. A bank providing that revolver relies on one ratio, so the trigger and the definition of what counts as drawn are most of its protection.

Second, the capacity to borrow more. Documents commonly allow further first-lien debt, through an incremental facility or a ratio basket, as long as first-lien leverage stays below a set level once the new money is in. In the example, a ratio of 3.75 times measured gross allows US$10m more (3.75 × 40 = 150, less 140). Measured net of the US$12m of cash, it allows US$22m. The netting choice made at signing decides how much new debt can join the existing lenders' rank.

Third, price and position. A lender asked to take second-ranking security reads first-lien leverage as the debt it stands behind. A first-lien lender asked to share its security with a newcomer reads the same figure as the dilution of its recovery. Where a bank and another secured creditor share the same assets in New Zealand or Australia, that is often settled in a deed of priority.