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How does a cash netting cap work in a net leverage covenant?

The proviso in the definition of net debt that decides whether a cash pile counts as covenant headroom, worked on one borrower: the ratio, the headroom, and what the borrower should do with the excess.

Julian R. Sterling · from How to Read a Credit Agreement

A cash netting cap limits how much cash the borrower may deduct from debt when it computes net leverage: cash above the cap still sits on the balance sheet but is ignored by the covenant. On an illustrative borrower with €290.0m of debt, €40.0m of cash and €50.0m of EBITDA, a €20.0m cap takes net leverage from 5.00x to 5.40x against a 5.50x covenant and cuts EBITDA headroom from €4.55m to €0.91m, 80.0 per cent of it, without a euro of trading changing.

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 →

The cap is in the definition of Consolidated Total Net Debt, usually as a proviso after the words "less cash and cash equivalents". It is one line, and it decides whether a cash pile is covenant headroom or just cash.

The assumptions

An illustrative sponsor-backed borrower at a quarterly test date. € millions.

Input	Value
Consolidated EBITDA, last twelve months	50.0
Gross debt	290.0
Unrestricted cash	40.0
Cap on cash netted	20.0
Maximum net leverage	5.50x

The calculation, step by step

The same balance sheet, with and without the cap.

Reading	Cash netted	Net debt	Leverage	EBITDA headroom	As % of EBITDA
No cap	40.0	250.0	5.00x	4.55	9.1%
Cap of 20.0	20.0	270.0	5.40x	0.91	1.8%

The cap adds 0.40 of a turn and removes €3.64m of the €4.55m of headroom. Uncapped, EBITDA could fall 9.1 per cent before a breach; capped, 1.8 per cent. In debt terms the borrower could add €25.0m uncapped and €5.0m capped.

What the cap does to the borrower's choices

The cap changes what each euro of cash is worth to the covenant, and therefore what the borrower should do with it.

• Cash above the cap is dead for the covenant. The €20.0m above the cap does nothing for the ratio while it sits in the account. Used to prepay debt, it moves gross debt to 270.0 and cash to 20.0, net debt to 250.0, and leverage back to 5.00x with €4.55m of headroom. Under a cap, prepayment is the only way the excess cash counts.
• Spending excess cash is free for the covenant. A €20.0m dividend paid from the cash above the cap leaves leverage at 5.40x. Without the cap the same dividend takes leverage from 5.00x to 5.40x. That is the lender's point: the cap stops a borrower from showing headroom made of cash it can pay away the next day.
• The cap binds hardest when cash builds up before a refinancing or an acquisition, which is also when the borrower is most likely to need its headroom.

What if: the level of the cap and a downside

Leverage and headroom at different caps. Cash of 40.0, debt of 290.0, EBITDA of 50.0, covenant 5.50x.

Cap	Net debt	Leverage	EBITDA headroom	As % of EBITDA
No netting	290.0	5.80x	−2.73	−5.5%
10.0	280.0	5.60x	−0.91	−1.8%
20.0	270.0	5.40x	0.91	1.8%
30.0	260.0	5.20x	2.73	5.5%
40.0 or more	250.0	5.00x	4.55	9.1%

Each €10.0m of cap is worth 0.20 of a turn and €1.82m of EBITDA headroom here. Caps are sometimes set as a percentage of EBITDA instead of a fixed amount. That sounds generous, but the percentage shrinks exactly when EBITDA falls. A grower written as the greater of a fixed amount and a percentage avoids this, because the fixed amount acts as a floor.

Net leverage as EBITDA falls, cash unchanged at 40.0.

EBITDA	Fall	No cap	Fixed cap 20.0	Cap of 40% of EBITDA
50.0	0%	5.00x	5.40x	5.40x
47.5	5%	5.26x	5.68x	5.71x
45.0	10%	5.56x	6.00x	6.04x

A 5 per cent fall in EBITDA is a pass at 5.26x without the cap and a breach at 5.68x with it. On a cap written as 40 per cent of EBITDA, the netted cash falls to 19.0 at the same time, and leverage reaches 5.71x.

When reading the definition, look for three things: whether the cap is a fixed amount, a grower or absent altogether; whether cash must be held in accounts over which the lenders have security before it can be netted; and whether the cap applies only to the financial covenant or also to the leverage tests that open baskets and incremental debt. The same cap can be tight for the maintenance covenant and irrelevant for the incurrence tests if they are defined differently.

The common mistakes

• Netting the balance sheet cash. The model takes cash from the balance sheet and the compliance certificate takes the capped amount. The model then shows 5.00x and the certificate 5.40x. Build the cap into the model's net debt line.
• Netting cash that is not unrestricted. Cash in a blocked account, collateral and cash trapped in subsidiaries usually falls outside the definition before the cap is applied. Which cash a lender should net at all is worked in how to calculate net debt to EBITDA.
• Reporting headroom in turns. 0.10 of a turn sounds like room. €0.91m of EBITDA, 1.8 per cent, is one bad month. The method is in how to calculate covenant headroom.

Takeaway

Net debt under a capped definition is gross debt less the smaller of cash and the cap. Here that is the difference between 5.00x and 5.40x, and between €4.55m and €0.91m of headroom. Read the cap before reading the ratio, and model it. The free workbooks for this book run a €15 million cash cap through a complete facility quarter by quarter: it first bites late in the life of the loan and adds 2.76 to net debt in the quarter after.

Questions readers ask

Why do lenders cap netted cash in a leverage covenant?

Because cash can be paid away the day after the test date. Without a cap, an illustrative borrower with 40.0 of cash shows 5.00x net leverage; a 20.0 dividend takes it to 5.40x. A 20.0 cap reports 5.40x from the start, so the covenant measures the debt the business actually carries rather than a cash balance it may not keep.

Does cash above the netting cap help the borrower at all?

Only if it repays debt. Left in the account it does nothing for the ratio. Used to prepay 20.0 of a 290.0 debt, it takes net debt from 270.0 to 250.0 and leverage from 5.40x to 5.00x, restoring 4.55 of EBITDA headroom against a 5.50x covenant.

Is a cash cap based on EBITDA better for the borrower?

Usually not when it matters. A cap of 40 per cent of EBITDA nets 20.0 at 50.0 of EBITDA but only 19.0 after a 5 per cent fall, so leverage reaches 5.71x against 5.68x under a fixed 20.0 cap. A cap set purely as a percentage of EBITDA shrinks exactly when headroom is needed; a grower with a fixed floor does not.

Also on this site

• How do you calculate covenant headroom on a leverage covenant?EBITDA headroom is EBITDA less net debt over the covenant: at 4.50x against 5.50x, EBITDA can fall €8.73m, 18.2 per cent. Without add-backs only 6.5 per cent.
• How do you calculate net debt to EBITDA for a credit analysis?Debt less usable cash over EBITDA on the same basis: one borrower reads 3.69x on a covenant definition and 4.50x once leases, pension and trapped cash are counted.
• How much equity does a covenant cure need: EBITDA or debt?A 5.90x borrower under a 5.50x covenant cures with 2.91 of deemed EBITDA or 16.00 of debt prepayment. The ratio is always the covenant level.
• How are break costs calculated on a loan prepayment?Fixed rate less redeposit rate, times the days left in the interest period: 50m prepaid at 3.10% EURIBOR against 2.65% costs 31,875, not the 315,208 with margin.
• How does a cap on EBITDA add-backs work in a credit agreement?A 20% cap on €40.0m of EBITDA allows €8.0m of a €12.0m synergy claim: leverage 4.79x. Drafted on post add-back EBITDA it allows €10.0m, 25 per cent.
• How does a grower basket work in a credit agreement?Capacity is the greater of a fixed amount and a percentage of Consolidated EBITDA: three baskets grow from €77.5m to €111.6m, €18.6m of it from add-backs.

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