The add-back cap worked on both drafting bases, and why a percentage cap makes covenant headroom smaller than the compliance certificate shows.
A cap on EBITDA add-backs limits the pro forma cost savings and synergies a borrower may add to Consolidated EBITDA to a percentage of EBITDA, and the add-back above the limit is simply disallowed. On an illustrative borrower with €40.0m of EBITDA claiming €12.0m of savings under a 20 per cent cap, €8.0m is allowed and leverage is 4.79x instead of 4.42x uncapped. If the cap is drafted on EBITDA after the add-backs, it allows €10.0m, 25 per cent, and leverage reads 4.60x.
Worked in full in How to Read a Credit Agreement by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Caps are the lender's main defence against a definition of Consolidated EBITDA that can be inflated with projected savings. They are usually one sentence at the end of the add-back clause, which is why their two most important features are missed: the base the percentage applies to, and the fact that a percentage cap shrinks when EBITDA falls.
| Input | Value |
|---|---|
| EBITDA before capped add-backs | 40.0 |
| Run-rate cost savings and synergies claimed | 12.0 |
| Cap on those add-backs | 20% |
| Net debt | 230.0 |
| Maximum net leverage covenant | 5.50x |
Without any add-back, leverage is 230.0 ÷ 40.0 = 5.75x, a breach. The add-backs are what keep this borrower compliant, so the cap is not a technicality here: it decides whether the certificate passes.
Cap on EBITDA before the add-backs. "Not to exceed 20 per cent of Consolidated EBITDA for such period, calculated before giving effect to such adjustments."
Allowed = MIN(claimed, cap × EBITDA before add-backs) = MIN(12.0, 20% × 40.0) = 8.0
Consolidated EBITDA = 40.0 + 8.0 = 48.0; leverage = 230.0 ÷ 48.0 = 4.79x; disallowed 4.0
In Excel: =MIN(Claimed,Cap*EBITDA)
Cap on EBITDA after the add-backs. "Not to exceed 20 per cent of Consolidated EBITDA for such period", with no further words, which most readings take to mean the number that already includes the adjustment. The limit is now circular: the add-back x must satisfy x ≤ 20% × (40.0 + x).
x ≤ cap ÷ (1 − cap) × EBITDA before add-backs = 0.25 × 40.0 = 10.0
Consolidated EBITDA = 50.0; leverage = 230.0 ÷ 50.0 = 4.60x; disallowed 2.0
In Excel: =MIN(Claimed,Cap/(1-Cap)*EBITDA)
A "20 per cent" cap drafted on the post-adjustment number is a 25 per cent cap on the real earnings. One clause in the definition is worth €2.0m of EBITDA and 0.19 of a turn of leverage on this borrower.
The covenant requires Consolidated EBITDA of 230.0 ÷ 5.50 = 41.82. On the pre-add-back drafting the certificate shows 48.0, so headroom appears to be 6.18. But every €1.0m lost from the underlying EBITDA also lowers the cap by €0.2m, so it costs 1.20 of Consolidated EBITDA. The breach arrives when 1.20 × EBITDA = 41.82, at underlying EBITDA of 34.85.
| Drafting | Consolidated EBITDA | Leverage | Underlying EBITDA at breach | Underlying headroom | Headroom, % |
|---|---|---|---|---|---|
| No cap | 52.0 | 4.42x | 29.82 | 10.18 | 25.5% |
| 20%, after add-backs | 50.0 | 4.60x | 33.45 | 6.55 | 16.4% |
| 20%, before add-backs | 48.0 | 4.79x | 34.85 | 5.15 | 12.9% |
Uncapped, a €1.0m fall in trading is a €1.0m fall in Consolidated EBITDA, and the 10.18 of headroom on the certificate is real. Capped, the certificate overstates it: 6.18 shown against 5.15 of trading the business can actually lose. The cap was negotiated to protect the lender, and it does, but it also makes covenant headroom more fragile than the compliance certificate suggests. The general method is worked in how to calculate covenant headroom; here the formula needs the extra factor of 1.20.
| Cap | Before add-backs: allowed | Consolidated | Leverage | After add-backs: allowed | Consolidated | Leverage |
|---|---|---|---|---|---|---|
| 10% | 4.00 | 44.00 | 5.23x | 4.44 | 44.44 | 5.17x |
| 15% | 6.00 | 46.00 | 5.00x | 7.06 | 47.06 | 4.89x |
| 20% | 8.00 | 48.00 | 4.79x | 10.00 | 50.00 | 4.60x |
| 25% | 10.00 | 50.00 | 4.60x | 12.00 | 52.00 | 4.42x |
A 25 per cent cap on the pre-adjustment base is the same as 20 per cent on the post-adjustment base. At 25 per cent post-adjustment the cap would allow 13.33, more than is claimed, so it does not bind at all and the borrower is effectively uncapped.
Check what the cap covers. Caps usually apply to run-rate savings and synergies, sometimes also to restructuring charges, rarely to everything. Add-backs outside the capped basket keep flowing in full. A cap that covers only synergies, in a deal whose bridge is mostly restructuring, protects very little.
The common mistake is to apply the percentage to the Consolidated EBITDA on the certificate and stop there. That is the post-adjustment reading by accident, and it allows a quarter more than the pre-adjustment reading. The second mistake is to read headroom off the certificate as if the cap were a fixed number. It is a percentage of the thing that is falling, so the true cushion is the certificate headroom divided by one plus the cap: 6.18 ÷ 1.20 = 5.15 here. When the add-back also has a run-off date, the claim itself falls away on a calendar: if the €12.0m claim drops to 6.0, Consolidated EBITDA is 46.0 and leverage 5.00x with no change in trading.
Find the base of the cap before computing anything. Before add-backs, the allowance is cap × EBITDA; after add-backs, cap ÷ (1 − cap) × EBITDA. Then compute headroom in underlying EBITDA, not on the certificate: €5.15m here, not €6.18m. The add-back cap is modelled quarter by quarter, with its run-off and the step-down it collides with, in the free workbook for this case, and the value of the whole bridge in leverage turns is worked in what an EBITDA add-back bridge is actually worth.
Caps are commonly expressed as a percentage of Consolidated EBITDA, and the base matters as much as the level. On illustrative figures of 40.0 of EBITDA, a 20 per cent cap on the pre-adjustment number allows 8.0, while the same 20 per cent on the post-adjustment number allows 10.0, equivalent to 25 per cent of the underlying earnings.
Solve the circular limit: the add-back x must not exceed the cap times EBITDA plus x, so x is at most cap divided by one minus cap times EBITDA. With a 20 per cent cap and 40.0 of EBITDA before add-backs, that is 0.25 times 40.0, so 10.0 is allowed and Consolidated EBITDA is 50.0.
Because the cap is a percentage of the EBITDA that is falling. Under a 20 per cent cap every 1.0 lost from trading removes 1.20 of Consolidated EBITDA. The certificate shows 6.18 of headroom above the 41.82 needed at 5.50x, but the underlying business can lose only 5.15 before the breach.
This article is one calculation from How to Read a Credit Agreement. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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