Two covenants that look independent at closing fail five basis points apart — and the one the chapter never runs in the downside is the one that goes first.
A unitranche is underwritten at 6.25 times leverage. The base case
returns a fixed charge coverage ratio of 1.70; the downside — a -12% revenue
decline with margins at 17% — returns 1.15. Thin, the chapter says, but
still above 1.00, and no covenant is breached. Both figures are right. What neither of them
says is how far the assumptions can move before they stop being right, and the answer turns
out to be 79 basis points of margin.
The three cases, with the test the chapter does not run
The downside is reported as a coverage ratio, and the coverage covenant is 1.10, so the
conclusion follows: 1.15 clears it. But this deal has two covenants, and the second one is
never run in the downside. Set it out and it changes the reading.
Case
Revenue, year 1
Margin
Coverage
Leverage
Verdict
Base
6%
22%
1.70
5.69×
no breach
Downside
-12%
17%
1.15
9.04×
no breach
Stress
-20%
15%
0.93
11.34×
breach
Covenants: fixed charge coverage 1.10, leverage 9.5×. Opening leverage 6.25× on debt of 137.5 against 22.0 of trailing EBITDA.
In the downside the coverage ratio falls from 1.70 to 1.15 — it has used
92% of its headroom. Leverage rises from 5.69 to 9.04 against a 9.5 covenant, using
88% of its own. Two tests that look independent at closing — one with
55 per cent of headroom, the other with more than three turns of cushion — are consumed
at almost exactly the same rate by the same scenario.
Which one goes first
Hold revenue at the downside level and walk the margin down. The coverage covenant fails
at a margin of 16.16%. The leverage covenant fails at 16.21% —
before it, by 5 basis points of margin.
Year-1 margin
EBITDA
Coverage
vs 1.10
Leverage
vs 9.5×
22.00%
19.36
1.448
pass
6.90
pass
20.00%
17.60
1.329
pass
7.63
pass
18.00%
15.84
1.210
pass
8.52
pass
17.00%
14.96
1.150
pass
9.04
pass
16.50%
14.52
1.120
pass
9.33
pass
16.16%
14.22
1.100
fail
9.53
fail
15.00%
13.20
1.021
fail
10.30
fail
Revenue held at the downside level, -12%. The two covenants fail 5 basis points of margin apart.
The ordering is the same from the other direction. Hold the margin at 17% and walk revenue
down instead: leverage fails at a decline of -16.1%, coverage at -16.7%. Whichever way the credit
deteriorates, the leverage test is reached first — and it is the test the chapter reports
no number for.
The more useful way to say it: the two covenants are 5 basis points of margin apart
in scenario space. A structure with a coverage covenant and a leverage covenant that fail
within five basis points of each other does not have two covenants. It has one test, written
twice, and the second one buys no independent protection at all. That is worth knowing before
conceding one of them in negotiation on the grounds that the other still holds.
What the whole cushion is worth, in one number
Everything above collapses to a single figure. Between the downside case and the first
covenant failure there is 0.69 of EBITDA — 4.6% of the downside EBITDA of
14.96. That is the entire margin for error the deal has left once an ordinary bad year has
happened. Not the 0.05 of coverage headroom the ratio suggests: 4.6% of the earnings.
Which is what makes the panel the workbook adds at the bottom of the case sheet more than
a formality. It asks which parts of the business are seasoned, and which of the unseasoned ones
have been stressed separately — and it flags any that have not with a line that reads
“this is the hole in the downside case”. The hole can now be sized.
How much unseasoned EBITDA it takes
Suppose a share of the earnings comes from something recently acquired or recently
launched — a unit with nine months of history — and the downside applied the group
assumptions to it uniformly, because that is what a single set of case assumptions does. How
far does that piece alone have to miss before the whole credit fails a covenant? The book
states neither the size of such a piece nor the decline it would suffer, so what follows is a
threshold rather than a forecast: read down to your own share.
Unseasoned share of EBITDA
Shortfall on that piece alone that breaches
In other words
5%
92.4%
essentially the whole piece
10%
46.2%
about half of it
15%
30.8%
about a third of it
20%
23.1%
about a quarter of it
30%
15.4%
about a sixth of it
40%
11.5%
about a ninth of it
Measured against the binding covenant, with revenue held at the downside level so that capital expenditure is not credited with falling. Below 4.6% of EBITDA, the piece cannot break the credit on its own.
A unit worth 15% of EBITDA needs to underperform the group downside by
30.8% to take the whole credit through a covenant. Nine months of operating
history is precisely the situation in which a third is an ordinary outcome rather than a tail
one — and the group downside, built on the legacy churn rate, will not show it. That is
the mechanism behind the case the chapter describes, priced.
And the stress case, which is the point of having one
The stress case — a -20% decline with margins at 15% — returns coverage of
0.93 and leverage of 11.34 times. It fails both tests, and it
fails the cash test too: the business no longer covers its fixed charges. A downside that
clears 1.00 tells you the deal survives an ordinary bad year. It does not tell you the distance
to the next one, and here that distance is 4.6% of EBITDA.
Three lines for the credit paper
Run the leverage covenant in every case, not only at closing, and report which covenant
fails first — if the answer is “both, at the same point”, say so, because the
committee is being shown two protections and owns one. Express the remaining cushion as a
percentage of downside EBITDA rather than as turns or as a ratio difference, because that is
the unit in which a single business line can consume it. And list the unseasoned EBITDA
separately with its own case: at 4.6% of the total or more, it can break the credit by itself
while every group assumption holds.
None of that requires a more sophisticated model. It requires running the one that exists
in both directions, and reporting the smaller of the two answers.
The workbook behind this article
Every figure above is a live formula in the companion file for
The Private Credit Investor, which reproduces both published coverage ratios exactly, runs the stress case, and carries the panel for unseasoned earnings that this article prices. It is free, and it needs no account and
no email address.
Should corporate debt be fixed or floating?78.1818 per cent of gross debt fixed, and a net floating exposure after cash of -608,000.00 — the proportion, not the instrument.
Does an undrawn revolver count as liquidity?67.4567 per cent of the headroom, and it leaves at a fall in annual revenue of 8.4127 per cent — not the 13.3333 per cent the board deck implies.
Does supply chain finance count as debt?66,049,315 released, and leverage of 2.7622× or 3.1362× depending on which balance the test is asked of — the second is a breach at today's EBITDA.
How do you set a minimum cash balance?Three components, 124,596,281 in total — and the double count that turns a margin of 27,403,719 into an apparent shortfall of -3,988,281.
Is a 2/10 net 60 discount worth taking?An annualised 14.8980 per cent against a revolver at 4.50 per cent — worth 5,471,890 a year, and 0.3132 turns of reported leverage.
At what wealth does a family office pay?A five-person office costs the same $2,442,000 at $100m as at $2bn. Against a tiered multi-family schedule the two curves cross exactly once.
Does the fulcrum move with enterprise value?A worked capital structure at three enterprise values. The break migrates from the first lien to the subordinated notes without a single document changing.
How many companies does a reserve pool defend?Holding pro rata to the Series D costs $14.76m per company. A $40m reserve defends 2.71 of forty — and 61 per cent of the cost is the last round.
How the GP catch-up is actually solvedMost write-ups state the catch-up formula then hardcode the answer. Set it as a solve and it moves on its own when the carry rate does.
Six ways to state the same fund's return7.12 per cent, 18.04 per cent, or 1.323 times the public market — one fund, one set of flows. The eleven-point gap is the valuation, and it is not cash.
The IRR at which a closed-ended fund merely tiesA drawdown fund advertising 13.25 per cent ties an evergreen netting 8.64. On committed rather than called capital, 78.7 per cent of the edge vanishes.
The month a remediation trigger has to be armed byMonth 8, on a one-year window and a 14-week hiring lead time. The date is 12W − L/4.33 and holds for any portfolio size — the book only changes the euros.
Two routes to the same NAVFive findings in one quarter-end close, and not one of them was a modelling error. Every one was a control that did not exist.
What a CBAM certificate buffer costs to holdCarry and protection are both linear in the buffer, so the break-even probability is identical at 5 per cent and at 30 — and 2027 costs exactly twice 2026.
What a clawback actually collateralises24 million recovers 13.20 net of tax and 7.20 is escrowed. The rule is e ≥ 1 − t, and every euro won on the tax clause lands uncollateralised.
What a co-investment programme actually saves37 basis points, and a 22.8 per cent total-loss rate erases it. At the usual per-deal cap a single failure is 37 per cent of the annual cohort.
What a diligence exercise actually recoversEighteen basis points is only the part that reaches the yield. Three of the four instruments never do, and the exercise is worth thirty-one.
What a follow-on reserve is actually worth0.019 turns under plain dilution, 0.285 under pay-to-play. The optimum is a property of the shareholders’ agreement, not of the portfolio.
What a lease mark-to-market is actually worth5,788,000 becomes 807,365 once the over-market stream, the expiry dates and the cost of re-letting are priced — and nothing at all below a 43.7 per cent renewal rate.
What a minimum payment actually does£81.53 leaves the account and £20.46 reaches the debt. On minimums alone the set clears in 258 months and repays 1.78 times what was borrowed.
What a month of delay costs in an enforcement463,000 euros of present value a month. No single error about enforcement, and no pair of errors, moves the indifference point from 58.7 cents to the 72 on the table.
What a pro rata cheque actually costsDefending costs 1.25 times the initial cheque across two rounds, not more in each — and below a 521 exit the follow-on dollars come back worth less than they cost.
What a subscription line does to the IRR20 per cent becomes 38.41 on the same asset while the multiple falls. Two dollars of interest buys 18.4 points, and the longer the line runs the cheaper each point gets.
What one point of fees actually costsOne point on the annual charge turns 738,846 into 567,961 over forty years — 23 per cent of the pot, and 2.43 of wealth lost per 1 of fee.
When the promote stops clearingCarried interest is not proportional to performance near the hurdle. It is a step function, and $2m of headroom is what stands between a promote and none.
Why a secondaries bid-ask gap has no zoneThe seller’s floor and the buyer’s ceiling are one formula at two rates. At equal required returns the zone is exactly zero — here it is 11.02 points apart.
Why refining a due diligence rubric makes it weakerThree of twelve managers carry a terminal flaw and the average approves all three. Splitting eight domains into sixteen makes it easier to hide, not harder.
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