The room a covenant reset buys, the fee and margin ratchet as actually collected, what the step-up does to the covenant nobody reset, and the recovery the lender gives up by waiting.
Price a covenant amendment in four numbers: the room it buys, the fee and margin step-up as actually collected, what it does to the covenant nobody reset, and the recovery the lender gives up by waiting. On the fictional Halstead Packaging loan, resetting leverage from 4.25x to 5.25x for a 1.00 per cent fee and a 50 basis point ratchet reads as a 3,600,000 package but collects 3,420,000, and the ratchet alone pushes the cash cover test to 1.1990x, below its 1.20x floor. Against 15,518,960 of recovery foregone by not enforcing for a year, the fee is the least consequential line in the letter.
Worked in full in Credit Analysis by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Amendments are negotiated on the fee because the fee is the number in the term sheet. The credit decision sits elsewhere: in how much room is bought, what the extra margin does to cash, and whether the lender is better off today than in a year.
| Input | Value |
|---|---|
| EBITDA, as adjusted by the lender | 28,460,000 |
| Senior net debt | 120,000,000 |
| Interest rate, all-in; amortisation a year | 7.4%; 5.0% |
| Cash available for debt service | 18,560,000 |
| Leverage covenant: as written / as reset | 4.25x / 5.25x |
| Cover covenant (cash over debt service) | 1.20x |
| Amendment fee; margin ratchet | 1.00%; 50 bp |
| Years left on the facility | 4 |
EBITDA admitted = debt / covenant; tolerated fall = 1 − admitted / EBITDA
4.25x: 120,000,000 / 4.25 = 28,235,294, a fall of 0.79%
5.25x: 120,000,000 / 5.25 = 22,857,143, a fall of 19.69%
In Excel: =1-Debt/Covenant/EBITDA. The reset buys 18.90 points of EBITDA cushion, 24.9 times the room the borrower had.
| Year | Balance at start | Ratchet at 50 bp |
|---|---|---|
| 1 | 120,000,000 | 600,000 |
| 2 | 114,000,000 | 570,000 |
| 3 | 108,000,000 | 540,000 |
| 4 | 102,000,000 | 510,000 |
| Ratchet collected | 2,220,000 |
The letter reads as a fee of 1,200,000 plus 600,000 a year for four years: 3,600,000. On a loan that amortises 5 per cent a year the ratchet collects 2,220,000, so the package is 3,420,000, 180,000 less. The credit paper can carry the headline; the pricing note should carry what arrives. Per point of EBITDA cushion bought, the headline costs the borrower 190,504.
Set against the loan's own economics, the fee is 13.5 per cent of a year's interest of 8,880,000, and 94.3 per cent of a year's expected loss of 1,272,964 at a 4 per cent default probability. The fee roughly prices one more year of the risk the lender already priced. It does not price the 18.90 points of room.
The leverage covenant is reset. The cover covenant is not, and the ratchet is paid in cash.
| Reading | Cash | Debt service | Cover |
|---|---|---|---|
| Before the amendment | 18,560,000 | 14,880,000 | 1.2473x |
| Ratchet added to debt service | 18,560,000 | 15,480,000 | 1.1990x |
| Fee also paid from the test period's cash | 17,360,000 | 15,480,000 | 1.1214x |
Cover = 18,560,000 / (120,000,000 × (7.4% + 5.0%) + 600,000) = 1.1990x
Cash needed at 1.20x = 1.20 × 15,480,000 = 18,576,000; shortfall 16,000
The borrower had 0.0473 of a turn of cover headroom. The ratchet takes all of it on the day the amendment is signed, by 16,000. Leverage covenants are fixed by adding room, which costs cash; cover covenants are measured on cash. A lender that resets one without recomputing the other has waived the second without charging for it, or has signed a default into the amendment.
Amendments are usually requested once the downside has arrived. On the book's downside path, an 8 per cent revenue fall carried through operating leverage of 2.2, EBITDA is 23,451,040: leverage is 5.12x and cover 0.91x, so the covenants as written are broken and the lender could act. The reset to 5.25x removes that trigger, because 5.12x passes it. A lender agreeing the amendment is therefore choosing not to enforce now. If the decline continues, EBITDA is 19,323,657 a year later. At a 4.0x exit multiple net of 6 per cent enforcement costs:
| When | EBITDA | Value net of costs |
|---|---|---|
| Enforce today | 23,451,040 | 88,175,910 |
| Enforce in a year | 19,323,657 | 72,656,950 |
| Recovery given up by waiting | 15,518,960 |
That is 4.31 times the whole headline package and 12.93 times the fee. It is measured before any interest and amortisation the lender collects during the year, which at 0.91x cover the borrower cannot fully pay, and before time value. If the downside is the likely path, the amendment is the expensive option however the fee is negotiated. If the borrower is likely to recover, the room is worth buying, and the conditions attached to it, information, a cash sweep, a capital expenditure floor, are worth more than an extra quarter point of fee.
Seen this way, the negotiation has three parts in order of value: whether to amend at all, which depends on the recovery path; the conditions, which decide whether the lender sees the next deterioration early; and the fee and margin, which are the smallest of the three and the only one usually argued over.
Compute the room bought in EBITDA, the package as collected, the cover after the step-up, and the recovery foregone, before discussing the fee. Where the margin itself breaks even against expected loss is worked in what probability of default a loan margin breaks even at, and how the downside amplifies through operating leverage in how operating leverage amplifies a lender's downside case. Every figure here is a live formula in the free workbooks for this book.
There is no standard level: the fee is negotiated with a margin step-up, so size the pair against what they buy. In the illustration a 1.00 per cent fee, 1,200,000 on 120,000,000, plus a 50 basis point ratchet buys 18.90 points of EBITDA cushion, 190,504 per point, and the fee is less than one year's expected loss of 1,272,964.
Yes, if a cash cover covenant is left unchanged. Adding a 50 basis point ratchet to 14,880,000 of debt service takes it to 15,480,000; with 18,560,000 of cash, cover falls from 1.2473x to 1.1990x against a 1.20x test, a shortfall of 16,000 on the day the amendment is signed.
Compare the recovery today with the recovery after another year on the likely path. On the illustrative downside, enforcement value falls from 88,175,910 to 72,656,950 in a year, so waiting gives up 15,518,960, 4.31 times the whole fee and ratchet package. If recovery is the likelier path, the amendment is worth buying.
This article is one calculation from Credit Analysis. 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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