From Debt Capacity to Levered Cash Flow

A term sheet is a promise to lend on stated terms, and between the term sheet and the signed agreement those terms tend to move. The lender's counsel drafts the agreement, and the covenant definitions come out slightly narrower than the ones in the business's pack. A personal guarantee from the owner, never mentioned in the term sheet, appears as a condition of closing because it is the bank's standard practice. The closing date approaches, the deal team is tired, and the owner signs. A year or two later the first bad quarter arrives, and the business finds out what the documents actually say.

The third span of the fourth bridge covers those two moments. It starts from debt capacity, a facility sized to the downside and agreed on a term sheet, and ends at levered cash flow: the debt in place on documented terms, interest and principal deducted as real costs, and the debt still in place after whatever the business meets.

What the measure is

Levered cash flow is the business's cash after the debt is in place, free cash flow to the firm with interest and principal actually deducted. On the first two spans the debt was hypothetical, first a capacity and then a term sheet, and its deductions were modelled. Here they are owed.

It comes third because it needs the facility the second span sized. It comes before free cash flow to equity, the anchor, because a buyer of the equity wants to see the debt in place and behaving, and a facility that has only been arranged shows neither.

The three drivers

Facility Close puts the sized debt in place on the terms that were chosen. The agreement's covenant definitions are made to match the ones the lender pack already reports, the debt schedule is built from the signed documents with a refinancing start date for each facility, and the owner's personal guarantees are released at closing or capped with a written trigger for release, so the debt stays with the company if the owner leaves.

Covenant Management keeps the debt in place on its own terms. Every covenant is tested monthly on the agreement's definitions, including the ones the lender tests only quarterly, and a trigger of the business's own, set well above the covenant, starts a written list of actions long before a test could fail. Coverage stays above its floor at every month-end and leverage under its ceiling at every quarter-end, and the record it leaves is two years of certificates with no breach, no waiver and no amendment made to rescue a covenant.

Rate Risk limits how much of the interest line can move, so that levered cash flow can be forecast when interest rates cannot. A written policy sets how much floating-rate debt is fixed, swapped or capped and for how long, the instruments sit on the debt schedule with their expiry dates and with accounting the outside accountant has reviewed, and the pack shows coverage under a sharp rise in rates every month.

A trigger well above the bar

The span rests on one idea: a covenant should never be the first warning.

There are two levels. The bar is the headroom to every covenant, at every quarter-end, that a lender treats as safe. The trigger is the business's own and sits well above it, and when headroom on any covenant falls to the trigger, a written action list starts. The list exists before it is needed, with named actions such as deferring a cost, drawing down a cost plan or opening a conversation with the lender, each with an owner and the headroom level that starts it.

With two levels, a breach needs two missed signals. The business acts at the trigger, months before the bar and long before the covenant itself. And because the covenants are tested monthly against a forecast that looks months ahead, the business acts when the forecast dips, before the reported figure does.

The action list deliberately leaves one thing out. Deferring growth spending is the action most finance leads reach for first, and Growth Capacity, on the previous span, has made it a board decision that needs a written reason. So the covenant is protected here without the growth plan being cut along the way where nobody sees it.

The guarantee and the owner

The personal guarantee is where the owner's interests and the business's are most easily confused. To a lender it is cheap security, putting the owner's house and savings behind the company's debt and keeping the owner engaged if things go wrong. To the owner it is a risk that sits outside the business and survives a sale. To a buyer it is an obstacle, because the guarantee has to be released and replaced before the deal can close, which makes the lender's consent one more condition of the sale.

That last effect makes the release more than a personal benefit. Removing a consent a buyer would otherwise need lowers the cost of selling the business, one of the four places value comes from on this bridge. The release is negotiated as a term of the facility and compared across term sheets before closing, when the business has the most leverage over it. Where the lender insists on security, the company's own assets replace the owner's, and the registrations are checked.

What it does to value

Covenant Management ranks second on the bridge, because a breach is the largest single loss the bridge can suffer: it puts the tax shield, the growth plan and the right to value the owners' cash directly at risk together. Its value is the breach probability at the headroom held, set against the probability at the bar, multiplied by what a breach would cost the owners in fees, forced sales and reinvestment cut.

Rate Risk ranks sixth. Its value is the fall in the probability of a rate shock and a breach that comes from the hedged share, multiplied by their cost, less the cost of the hedge itself. A hedge that costs more than the distress it avoids moves value the wrong way, so the policy ratio is set where the two cross, and the finance lead is paid for holding the ratio, not for exceeding it.

Facility Close has no rank of its own. Releasing the owner's guarantee moves default risk from the owner to the lender, who prices it into the facility's terms, so the release leaves the owners' risk where it was. It enters the valuation through the cost of selling the business. The rest of the driver is permission: the documents that make the equity valuation permissible at all.

How the drivers depend on each other

The close executes a decision already made, the term sheet chosen under Facility Sizing. It also needs the shareholder loans subordinated under Capital Structure File, since a senior lender will not close with shareholder claims ranking alongside it, and counsel experienced in senior credit agreements, budgeted before the term sheet is signed.

Covenant Management has nothing to manage until the agreement exists. It reads its tests from the on-time pack, and acting on a forecast dip needs the levered forecast. Rate Risk implements the rate stress and policy built under Levered Forecast, which keeps the hedging a matter of policy and not of anyone's view of the market, and it hedges the exposure on the debt schedule that the close produced.

How the span comes undone

The span can fail in five ways, and each has its safeguard. A covenant breach is what the trigger and its action list, kept in force, are there to prevent. Leverage can creep past capacity, so the leverage ceiling is reapproved every year against the latest adjusted EBITDA.

The owner's guarantee tends to return at renewal, because the bank asks and it is the fastest way to renew, so release is written into every renewal as a requirement and reinstating a guarantee needs a decision recorded in writing with the owner's signature. A maturity can arrive without a committed refinancing, which is why every facility on the debt schedule carries a refinancing start date that every month's pack shows. And floating-rate exposure goes unhedged when a hedge expires and nobody replaces it. Expiries sit on the debt schedule with replacement starting well before each one, and the rate policy is reviewed at every refinancing so that no new facility closes without its hedging decided.

Crossing the span

The span is crossed when covenants are met with headroom and managed by a finance function instead of the owner, when the owner's guarantees are released or on a written path to release, and when interest-rate exposure is within the written policy. The bridge's last span then asks the debt to prove itself.