From Levered Cash Flow to Free Cash Flow to Equity

A business that has just signed its first senior facility has proved a great deal. Its cash is measured, its forecast has a downside, its facility is sized to it, its covenants are tested monthly and its owner's guarantee is on a path to release. It has not yet proved that any of this works. Every quarter since closing may have been a good one, and a buyer or a new lender reading that record will assume, reasonably, that the first bad quarter is the one that breaks it.

The last span of the fourth bridge supplies the proof. It starts from levered cash flow, with the debt in place and deducted, and ends at free cash flow to equity: the cash left for the owners after interest, principal and net new borrowing, with the debt shown to have survived stress, the lender relationship belonging to the company, and the owners' cash valued behind the lender in a way an equity buyer can recompute.

What the measure is

Free cash flow to equity is free cash flow to the firm, less interest after tax, less principal repaid, plus net new borrowing: the cash the owners could take out of the business in a year once the lenders have been paid what they are owed.

In the illustration, a business with $765,000 of free cash flow to the firm and a $2.8 million facility at 8 percent, repaid over seven years, pays $168,000 of interest after tax and $400,000 of principal in the first year, and leaves $197,000 for its owners. The figure is small in the early years of an amortizing loan, because most of the cash is going to repay the lender, and it grows as the debt falls. Leverage does not hand the owners more cash now. They take out less, and each year's principal repaid leaves them owning a larger share of the business's value. In the illustration, with free cash flow to the firm held at $765,000, the owners' cash rises from $197,000 in the first year to $341,000 in the seventh.

The measure comes last because it is the residual, and a residual can only be computed once every claim ahead of the owners is known, in place and being paid.

The three drivers

Seasoning proves that levered cash flow survives stress. The debt has to be serviced on schedule through at least one soft quarter, with revenue well below its recent average, or through a refinancing, with no covenant breached and no owner's money put in to cure one. A short memo records what fell, what the covenant tests showed, what was done from the action list, and the bank statements' evidence that no owner funds came in. Free cash flow to equity goes into the monthly pack with interest, principal and net borrowing on separate lines.

Lender Relationships makes net borrowing a decision the company can take without the owner. The finance lead owns the lender relationship, prepares the pack and the certificates and is the lender's day-to-day contact, with a named deputy. A second lender has given an indication of terms within the last year, on current figures. And every near maturity is covered by a committed refinancing or by cash set aside.

The Equity Value File produces what the valuation of the owners' cash needs. It reconciles valuing the owners' cash directly with valuing the whole enterprise and subtracting the debt, relevers the cost of equity every quarter as the debt is repaid, and carries the competitor map forward, checked against the lender's view of the industry. It also holds the scenario file under leverage, a log of every recapitalization and sale indication received, the inputs for valuing a levered holder's position, and the holder's return since the facility closed.

Why a soft quarter is worth more than a good year

A business with eight good quarters since closing has a less valuable record than one with seven good quarters and one bad one it handled. That runs against intuition until you ask what the lender, and the equity buyer behind the lender, are underwriting. Good quarters service any debt. What they need to know about is the bad quarter that will eventually come, and only a record that includes one tells them: revenue down, the trigger reached, the action list started, coverage dipping and recovering, and the debt paid on schedule without the owner's money.

Where no quarter has been soft enough to count, a planned refinancing on the business's own record, with a lender who has read the packs and the covenant history, proves the same thing by another route: the debt is the company's, and the company can carry it without help.

The owner steps back from the bank

Owners often find the second driver the hardest, because it asks them to give up a relationship they built. In many owner-run businesses the bank relationship is the owner's long friendship with a branch manager. It has real value, and it belongs to two people, either of whom can leave.

So the relationship moves to the finance lead, at a joint meeting with the lender and then in the finance lead's job description and agreement, with a deputy who meets the lender too. The owner refers every call onward until the relationship manager, asked who they call, names the finance lead. A second lender's recent indication then gives the business a benchmark of its own at every renewal, so it negotiates from its record and not from its lender's knowledge that there is no one else.

What it does to value

All three drivers rank low on the bridge, because most of what they do is reveal value or correct error.

Seasoning ranks ninth. It is credited only with the fall in breach probability that comes from terms the seasoned record wins and that change the structure itself: a covenant reset to wider headroom, the release of a covenant that would otherwise spring into force, or a pause in repayments in a soft quarter. Knowing more about an unchanged structure changes what is known about the risk and leaves the risk where it was, so it is not counted. Owner funds injected to cure a covenant come off the equity value at their full amount.

Lender Relationships ranks tenth. Its value is the fall in the probability of a failed refinancing, from covered maturities and a second lender's indication, multiplied by what a forced refinancing or sale would cost the owners. The deeper pool of buyers that the second lender's interest creates is price, counted in the discount for illiquidity and never as value of the business.

The Equity Value File ranks last. It adds no value and removes two errors: the gap between the two ways of valuing the equity, and a cost of equity held flat while the debt behind it is being repaid.

How the drivers depend on each other

Seasoning rests on the previous span. Its memo cites the monthly covenant tests from Covenant Management, without which the period cannot be shown to have been clean, uses the debt schedule from Facility Close to show what was due and when, and shows the action list in use, which is the evidence that the business acted on a plan and was not simply lucky.

Lender Relationships needs a finance lead already in the seat, from Management Install on the second bridge, because a relationship can only be handed to someone who is there. It needs a year of on-time packs, because a second lender gives an indication on the business's history, and the debt schedule's refinancing dates, because those are the maturities it covers. The value file needs all of it, since its inputs are computed from the record the other two create.

How the span comes undone

Three of the span's failures belong to the drivers. A covenant can be breached in the next soft quarter, and the defences are the last soft quarter's actions folded into the standing action list, so the next one is handled faster, and a seasoning memo written and kept by the finance lead, so the record of how the business carried its debt does not live in the owner's memory. The finance function can hollow out, leaving the owner back managing the bank, which a named deputy and a current bank mandate prevent. And a maturity can arrive uncommitted, which the refinancing calendar in every monthly pack, with each maturity's start date and status, is there to catch.

The value file decays in its own ways. The cost of equity is left unmoved while leverage changes. The two valuation routes drift apart and nobody reconciles them. The lender's view of the market stops reaching the competitor map, a scenario the file once priced is moved into the required return without anyone saying so, and the holder's return goes unmeasured while the debt is serviced. The safeguards for those belong to the anchor.

Crossing the span

The span is crossed when net borrowing is in the number, when the business has serviced its debt through a soft period or a refinancing, and when a second lender has shown it would refinance the debt. That completes the fourth bridge. What the owners' cash is worth behind the lender, and to the buyer who will pay for it, is the subject of the essay on what free cash flow to equity is worth.