Free-and-clear, the ratio basket and the one sentence on concurrent incurrence, run on a borrower at 4.00x, then run again with add-backs.
Incremental facility capacity is the free-and-clear amount plus whatever ratio debt fits under the pro forma leverage test: free-and-clear + (ratio level × EBITDA − pro forma net debt). On an illustrative borrower at 4.00x with €80.0m of Consolidated EBITDA, a free-and-clear basket of the greater of €70.0m and 100 per cent of EBITDA plus a 4.50x first lien ratio basket gives €120.0m of new pari passu debt, taking leverage to 5.50x. If the free-and-clear tranche had to count in the ratio test, capacity would be €80.0m.
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 →
An incremental (or accordion) clause lets the borrower add term loans or commitments under the same agreement, ranking with the existing lenders, without their consent. In current sponsor documentation the amount is usually the sum of three pieces:
The sum is not a matter of adding three numbers from the term sheet. It depends on the EBITDA definition, on whether incremental proceeds may be netted against debt, and on the order in which the pieces are deemed incurred.
| Input | Value |
|---|---|
| Consolidated EBITDA, last twelve months | 80.0 |
| First lien term loan outstanding | 340.0 |
| Cash | 20.0 |
| Free-and-clear: greater of | 70.0 and 100% of EBITDA |
| Ratio basket: pro forma first lien net leverage no higher than | 4.50x |
Net debt = 340.0 − 20.0 = 320.0; leverage = 320.0 / 80.0 = 4.00x
Free-and-clear = MAX(70.0, 100% × 80.0) = 80.0
Ratio capacity = 4.50 × 80.0 − 320.0 = 40.0 (proceeds not netted, free-and-clear disregarded)
Total = 80.0 + 40.0 = 120.0; pro forma leverage = (320.0 + 120.0) / 80.0 = 5.50x
Excel: =MAX(FC_Fixed,FC_Pct*EBITDA)+MAX(0,Ratio*EBITDA-(Debt-Cash))
Two drafting points carry the result. First, the ratio is tested without netting the cash proceeds of the new debt; if proceeds sitting on the balance sheet could be netted, pro forma net debt would stay at 320.0 and the ratio test would never bite. Second, the agreement says that when ratio debt and free-and-clear debt are incurred together, the ratio is calculated without the free-and-clear tranche. That one sentence is worth €40.0m here.
Suppose instead the free-and-clear tranche is used first and counts as debt in the later ratio test. Net debt becomes 400.0, leverage 5.00x, already above 4.50x, so ratio capacity is nil and the total is €80.0m. Many sponsor documents now prevent this by deeming ratio debt incurred first and allowing the borrower to reclassify free-and-clear debt as ratio debt later, when EBITDA has grown. The reclassification refills the free-and-clear basket, so the same €80.0m can be borrowed twice over the life of the loan.
With a grower basket at 100 per cent of EBITDA, the maximum pro forma leverage is simply the ratio level plus one turn: 4.50x + 1.00x = 5.50x, at any EBITDA level, provided the borrower starts inside the ratio test and the percentage limb is above the fixed floor. Below that, the floor pushes the ceiling higher still, as the next section shows. The headline 4.50x is not the ceiling an existing lender is exposed to.
Both pieces are multiples of Consolidated EBITDA, so every add-back accepted in the definition creates debt capacity. Hold the underlying business at €80.0m and add add-backs:
| Add-backs | Consolidated EBITDA | Free-and-clear | Ratio debt | Total capacity | Pro forma leverage, defined | Pro forma leverage, underlying |
|---|---|---|---|---|---|---|
| 0.0 | 80.0 | 80.0 | 40.0 | 120.0 | 5.50x | 5.50x |
| 5.0 | 85.0 | 85.0 | 62.5 | 147.5 | 5.50x | 5.84x |
| 10.0 | 90.0 | 90.0 | 85.0 | 175.0 | 5.50x | 6.19x |
| 15.0 | 95.0 | 95.0 | 107.5 | 202.5 | 5.50x | 6.53x |
Each euro of add-back creates 5.5 euros of incremental capacity: 1.0 through the grower basket and 4.5 through the ratio. The leverage on the defined number never moves from 5.50x, so a compliance certificate would show the same ratio in every row. On the business as it actually trades, €15.0m of add-backs takes the borrower to 6.53x.
The fixed floor works in the borrower's favour in the other direction. If EBITDA falls to €60.0m, leverage is already 5.33x and the ratio basket is closed, but the free-and-clear amount cannot fall below €70.0m, so the borrower can still add €70.0m and reach 6.50x.
The usual error is to read capacity from the term sheet as "€70.0m plus whatever keeps us under 4.50x" and to stop there. That reading misses the grower (80.0, not 70.0), misses the concurrent-incurrence language (which adds the full free-and-clear on top of the ratio debt), and computes the ratio on an EBITDA figure the lender has haircut rather than the defined one the borrower will certify. An existing lender should run the clause on the borrower's own definition and state the answer as pro forma leverage on underlying EBITDA. A further incremental tranche priced above the existing loan also triggers the MFN, whose value is worked in what a 50 basis point MFN pays the existing lender.
The basket sheet in the free workbook for this case sizes the grower baskets quarter by quarter on both the defined and the unadjusted EBITDA, and how to calculate covenant headroom shows what the same add-backs do to the maintenance test.
It is incremental debt the borrower can raise without meeting any leverage test, usually the greater of a fixed amount and a percentage of EBITDA. In the worked case it is the greater of €70.0m and 100 per cent of EBITDA, so €80.0m at €80.0m of EBITDA, and still €70.0m if EBITDA falls to €60.0m.
Usually not: agreements typically exclude the cash proceeds of the incremental debt from netting when testing pro forma leverage. If netting were allowed, net debt would not rise when the loan is drawn and held as cash, so in the example the 4.50x test would never bite and the ratio basket would be unlimited.
If free-and-clear debt counts in the ratio test, using it first pushes leverage from 4.00x to 5.00x and closes the 4.50x ratio basket, so capacity is €80.0m. If the ratio is tested without it, as many sponsor documents provide, the borrower gets €40.0m of ratio debt plus the full €80.0m, €120.0m in total.
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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