Lenders stress EBITDA as routine and check rates at today's print. Solving the covenant for the base rate shows how little room a levered floating-rate loan has.
Solve the covenant for the base rate: break-even SOFR = EBITDA ÷ (minimum interest cover × debt) − spread. On an illustrative unitranche of $240.0m at 6.0x a $40.0m EBITDA, priced at SOFR plus 5.75 per cent, a 1.50x interest cover covenant breaks when SOFR reaches 5.36 per cent, 136 basis points above an assumed 4.00 per cent today. Swapping half the debt lifts the break-even to 6.97 per cent; a 10 per cent fall in EBITDA cuts it to 4.25 per cent, only 25 basis points of headroom.
Worked in full in The Private Credit Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Floating-rate direct loans pass every move in the base rate straight into the borrower's interest bill. Lenders stress EBITDA as a matter of routine, but the rate side is often checked only at the current SOFR print. The question a credit committee should ask is the reverse one: how far can the base rate rise before the covenant, or the cash flow, gives way?
| Input | Value |
|---|---|
| EBITDA, last twelve months | $40.0m |
| Leverage | 6.0x |
| Unitranche, fully floating | $240.0m |
| Margin over SOFR | 5.75% |
| SOFR today | 4.00% |
| Minimum interest cover covenant, EBITDA ÷ cash interest | 1.50x |
| Maintenance capex | $4.0m |
| Cash taxes | $2.0m |
All-in rate: 4.00% + 5.75% = 9.75%. Interest: $240.0m × 9.75% = $23.40m.
Interest cover: $40.0m ÷ $23.40m = 1.71x, against a 1.50x minimum.
Each 100 basis points on SOFR adds $2.40m of interest. At SOFR plus 100, interest is $25.80m and cover falls to 1.55x.
Maximum interest the covenant allows: $40.0m ÷ 1.50 = $26.67m.
Maximum all-in rate: $26.67m ÷ $240.0m = 11.11%. Less the 5.75% margin: break-even SOFR = 5.36%.
Headroom: 5.36% − 4.00% = 136 bp.
In Excel: =EBITDA/(ICR_min*Debt)-Spread.
The formula shows why leverage matters so much on the rate side. Break-even all-in rate is simply the reciprocal of leverage divided by the covenant: 1 ÷ (6.0 × 1.50) = 11.11 per cent. A borrower at 6.0x can never pay more than about 11 per cent all-in and stay compliant, whatever SOFR does.
The covenant is not the only line. The borrower stops covering interest from cash flow when EBITDA less capex and tax, $34.0m here, no longer pays the bill.
Cash break-even all-in rate: $34.0m ÷ $240.0m = 14.17%. Break-even SOFR: 14.17% − 5.75% = 8.42%, 442 bp of headroom.
Cash cover today: $34.0m ÷ $23.40m = 1.45x.
So the covenant trips long before the cash runs out, which is its job: it hands the lender a seat at the table at 5.36 per cent SOFR, while the borrower can still pay until 8.42 per cent.
Suppose the sponsor swaps half the loan, $120.0m, into a fixed base rate of 3.75 per cent. The hedged half costs 3.75% + 5.75% on $120.0m, $11.40m a year, whatever SOFR does.
Break-even SOFR on the unhedged half: ($26.67m − $11.40m) ÷ $120.0m − 5.75% = 6.97%.
The hedge adds 161 bp of rate headroom. Interest today is $23.10m and cover 1.73x, almost unchanged.
Each 100 basis points on SOFR now adds $1.20m of interest instead of $2.40m, because only the unhedged half moves, so the headroom over today's 4.00 per cent more than doubles, from 136 to 297 basis points. That is why lenders often require a hedge on a stated share of the loan for the first years.
| EBITDA fall | 5.0x ($200m) | 6.0x ($240m) | 7.0x ($280m) |
|---|---|---|---|
| 0% | 7.58% | 5.36% | 3.77% |
| 10% | 6.25% | 4.25% | 2.82% |
| 20% | 4.92% | 3.14% | 1.87% |
Read it against the assumed 4.00 per cent SOFR. At 7.0x the covenant is already breached today, since 3.77 per cent is below the current rate. At 6.0x, a 10 per cent EBITDA fall leaves only 25 basis points of rate headroom, and a 20 per cent fall breaches at today's SOFR. At 5.0x the loan survives a 20 per cent EBITDA fall with SOFR as high as 4.92 per cent.
The usual error is to run the rate stress and the EBITDA stress one at a time and report two comfortable numbers: EBITDA can fall 12.2 per cent at today's SOFR (to $35.10m) before the covenant breaks, and SOFR can rise 136 basis points at today's EBITDA. Both are true, and neither is the risk. Rates tend to rise when the economy is running hot and stay high into the slowdown that follows, so the two shocks can arrive together. A 10 per cent EBITDA fall with SOFR up 100 basis points gives $36.0m over $25.80m, an interest cover of 1.40x: breached, though each shock alone passes.
For the credit memo: state the break-even SOFR at the downside EBITDA, not the base case, and state it net of any hedge, with the hedge's expiry date beside it. A hedge that rolls off before the loan matures protects only the years it covers.
The combined effect of two stresses is examined further in whether a combined downside is worse than the sum of its parts, and covenant headroom on the leverage side in how to calculate covenant headroom.
Turn the coverage covenant into a base rate: break-even SOFR is the reciprocal of leverage divided by the covenant level, less the margin. At 6.0x and a 1.50x covenant that ceiling is 11.11 per cent all-in, or 5.36 per cent SOFR on a 5.75 per cent margin, and it falls fast as EBITDA weakens. The book's own model of a unitranche at 6.25x, with its base, downside and stress cases, is reproduced in the free workbook for this case.
Divide EBITDA by the product of the minimum interest cover and the debt to get the maximum all-in rate, then subtract the margin. For $40.0m of EBITDA, $240.0m of debt and a 1.50x covenant, the maximum all-in rate is 11.11 per cent; less a 5.75 per cent margin, SOFR can reach 5.36 per cent before the covenant breaks.
It removes the hedged share of the debt from the rate stress. In the illustrative case, swapping half of a $240.0m loan at a 3.75 per cent base rate fixes $11.40m of interest and lifts the break-even SOFR from 5.36 to 6.97 per cent, 161 basis points of extra headroom, for as long as the hedge runs.
Because they can arrive together. On their own, a 10 per cent EBITDA fall or a 100 basis point rise in SOFR each leaves interest cover above 1.50x in the worked case. Combined, cover falls to 1.40x, with $36.0m of EBITDA against $25.80m of interest, and the covenant is breached.
This article is one calculation from The Private Credit Investor. 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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