Not when the target reports under a framework in which the rent is already an operating expense. Balmacara's 4,150,000 of uncapitalised leases sit inside the 27,600,000 of EBITDA the deal is priced on. Putting them in the covenant numerator and charging interest on them as well takes year-one accretion from minus 15.7134 per cent to minus 19.8485 per cent, a move of 4.1351 points from one line in a sale and purchase agreement.
The punitive version, computed in full
After completion the group's covenant debt is 367,019,087: the acquirer's existing 186,700,000, the 120,720,000 of new debt raised for the purchase, the 38,500,000 of the target's net debt that is assumed rather than refinanced, the earn-out at its fair value of 9,649,087, and the 11,450,000 of debt-like items the covenant schedule captures. Combined EBITDA is 123,600,000, being 96,000,000 and 27,600,000. The ratio is 2.9694 times, which lands on the 2.50 to 3.00 rung: 125 basis points over a base of 4.00 per cent, a rate of 5.25 per cent. Year-one earnings per share come out 15.7134 per cent below the acquirer's standalone 0.417362.
Add the leases to the covenant numerator. The debt becomes 371,169,087, and the earn-out is worth 203,370 less because the rate that discounts it has risen, so the numerator is 370,965,717. Divided by 123,600,000 that is 3.0013 times. The rung is crossed. The margin goes from 125 to 200 basis points and the rate from 5.25 to 6.00 per cent, and it goes there on everything the group owes that bears interest, which is 362,769,087, not on the 4,150,000 that caused it. Then charge interest on the leases as well: 4,150,000 at 6.00 per cent is 249,000 a year.
treatment of the 4,150,000 of leases
leverage
margin
year-one accretion
Outside the covenant, no interest charged
2.9694
125 basis points
minus 15.7134 per cent
In the covenant numerator
3.0013
200 basis points
minus 19.4994 per cent
In the numerator and bearing interest
3.0013
200 basis points
minus 19.8485 per cent
Every step follows from the one above it. The arithmetic contains no error, and the answer is wrong twice.
The rent is already inside the EBITDA
Balmacara reports under local GAAP, where the lease is an operating lease and the rent is an operating expense. It is already inside the 27,600,000 of EBITDA the whole deal is priced on, and inside the 21,200,000 of operating profit the combined income statement inherits. Capitalise the liability and charge interest on it, and the same cash is billed twice: once as rent above the line, once as interest below it. At 5.25 per cent the second bill is 217,875 a year. After tax at 25 per cent that is 163,406, or 0.001275 per share across the 128,153,283 shares in issue after the equity raise, which against a standalone 0.417362 is 0.3055 of a point.
In the punitive version the rate is 6.00 rather than 5.25 per cent, so the double bill is 249,000 and the cost is 0.3491 of a point. That is exactly the distance between minus 19.4994 and minus 19.8485. The interest leg is nothing but the double count, scaled up by the margin the covenant leg has triggered.
The covenant leg fails for the same reason, one step removed. A leverage ratio is a fraction. Under a framework that capitalises leases the liability enters the numerator and the rent leaves operating expenses, so EBITDA in the denominator rises. Under a framework that does not, neither happens. Taking the numerator from the first and the denominator from the second is not conservatism; it is a fraction assembled from two worlds, true in neither. No lender applies it.
A small line reprices a large balance
The covenant leg alone is worth 3.7860 points, and the size of it is the surprise. The margin step is 75 basis points. Applied to the 362,769,087 of group borrowings that bear interest after completion, that is 2,720,768 a year; after tax at 25 per cent, 2,040,576; across 128,153,283 shares, 0.015924 per share; against a standalone 0.417362, 3.8152 points. The model's own figure is 3.7860, so the hand calculation is 0.0292 of a point too harsh; the gap is the loop between the rate, the earn-out's fair value and the price allocated.
item removed from the covenant
amount
leverage
year-one accretion
Unfunded pension deficit
7,200,000
2.9112
minus 15.7134 per cent
Provided tax litigation
2,450,000
2.9496
minus 15.7134 per cent
Declared unpaid dividend
1,800,000
2.9548
minus 15.7134 per cent
Three deletions, three different leverage ratios, one accretion figure repeated three times.
The reason is the rung. At 2.9694 times the group is already under 3.00, and taking debt out of the numerator only moves it further under. Nothing reprices, so nothing changes. The leases are different not because 4,150,000 is a large number but because they are the only item that pushes the ratio the other way, across a threshold sitting 0.0306 of a turn above where the deal lands. Reaching 3.00 times from 2.9694 would take 9,452,283 more net debt at the target.
The item that trips a ladder is never the item that pays for it. A 4,150,000 line reprices 362,769,087 of borrowings, while the three larger items on the same schedule — 7,200,000, 2,450,000 and 1,800,000 — move the answer by nothing at all. A schedule of debt-like items is not a list of numbers to be worried about in proportion to their size. It is a list of inputs to a step function, and the step is where the money is.
What to do with it
When an item appears on a debt-like schedule, establish which reporting framework the target uses, then establish where the associated expense already sits. If it is already inside the EBITDA the deal is priced on, it cannot also carry interest below the line, and it cannot enter the leverage numerator unless the denominator is restated at the same time. That is one question and it takes a phone call.
Then separate the perimeters, because they are not the same set. On this deal the price falls by all 15,600,000 of debt-like items, 11,450,000 of them enter the covenant test, and 7,200,000 of them bear interest afterwards. The leases belong to the first perimeter only. The punitive version moved them quietly into all three, and it looked rigorous while doing it: treating an obligation as debt, charging interest on it and putting it in the covenant is the choice that sounds prudent out loud, and prudent choices are the ones nobody audits.
The workbooks behind this article
Every figure above is a live formula in the free companion files for
Mergers and Acquisitions. Each workbook ends with a Checks sheet
setting the printed figure beside the computed one. No account and no email address.
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