Inspecting Free Cash Flow to Equity

The fourth bridge ends with a business that carries debt and has shown that it can, along with a list of what it produced to prove it. The fifth bridge begins by checking that list line by line, each line against a bar.

Most of the checking here is done by the lender's people and the professionals a lender relies on: the credit review, the credit committee, counsel, the outside accountant, an independent model reviewer. That suits the moment. A yield buyer is about to be asked to rely on a payout that comes after the debt service, and the lender stands in front of it. Before it trusts the payout, it wants to see that the lender is satisfied.

Is the lender's number real?

The first group of lines asks whether the figures a lender relies on are the business's own, and whether they hold.

The credit review starts with the lender packs. It wants an unbroken run of monthly packs, each delivered promptly after month-end, each reconciling to the statements with no unexplained difference, and each showing cash flow available for debt service and free cash flow to equity on the loan agreement's own definitions. A gap in the run, or a pack that needed explaining, is the first sign that the number was put together for the lender's benefit.

The capital structure has to sit in one file. That means a capitalization table reconciled to the share register and the shareholder agreement, and one schedule of every debt and debt-like obligation: leases, deferred purchase price, earn-outs, deferred pay, customer deposits outside the peg and shareholder loans. Every shareholder loan is subordinated in writing, and diligence should turn up no obligation the schedule leaves out.

Then the covenant record. The inspector reads the compliance certificates over the same run and expects no breach, no waiver and no amendment made for a covenant reason. Coverage has to have stayed comfortably above the covenant level at every month-end on a trailing basis, and leverage within what the cash flow can carry, with real headroom to every covenant, at each recent quarter-end.

There is no partial credit on these lines. A yield buyer is about to capitalize what remains after debt service, and a single breach in the record tells it that the remainder was once at risk of disappearing.

Is the debt the company's, and safe?

The next lines ask whether the debt is under control, on documented terms, and independent of the owner.

The credit committee reads the levered forecast. It runs by month across the next several years, in a base case and a downside in which revenue falls well short of plan and rates rise above what the market expects, with every covenant met in the downside. The committee also looks back. Last year's levered cash flow has to have landed close to what was forecast for it, and the committee treats that as a year of monthly observations, which is evidence and not a guarantee. The downside is narrowed only as far as that record earns.

The rate policy is written, and either a substantial share of the floating debt is hedged for a meaningful period or a stress shows coverage still above the comfort level when rates rise sharply. The debt schedule matches the executed documents. Maturities are spread so that no single year carries a large share of the debt, and every maturity coming due soon is covered by a committed refinancing or by cash on hand.

Counsel looks at the owner's position. Every personal guarantee is released, or capped with a written trigger for its release, and no personal asset of the owner secures company debt. Counsel also checks that the registered security matches the documents.

Two lines test whether the debt has been lived with. It has to be seasoned: serviced on schedule through at least one genuinely soft quarter, or through a refinancing, with no breach and no money put in by the owner to cure one. And the finance function owns it. A finance lead, with a named deputy, prepares the pack and the certificates and is the lender's day-to-day contact, and a second lender has recently given an indication of terms. The lender itself confirms who it calls.

Does growth survive the debt?

Four lines check the work that made the fourth bridge more than a lending exercise.

The levered forecast has to fund the reinvestment plan after debt service, in the base and downside cases, from retained cash or undrawn capacity, with no call on the owners and no covenant breached. Counsel reads the loan agreement against the plan. It should carry a capital spending basket, an acquisition or permitted-investment basket and whatever carve-outs the plan needs, each at or above the matching year of the plan, so that no year of the plan can be funded only with the lender's consent. The baskets should have been on the term sheet before signing; a basket won later by amendment is one the lender can take back the same way.

The undrawn line is sized to the largest cumulative funding gap in the downside. Every condition to drawing it is met in the downside forecast in the month the draw would be needed, the commitment fee is paid and the line has not expired. And the reinvestment register shows, for every year since the facility closed, growth spending at or above plan, no project deferred or cancelled to protect a covenant or a distribution, and returns still above the cost of capital. A quality-of-earnings review checks the register against the covenant certificates, because a deferral made to pass a test would show up where the two meet.

These lines carry more weight on the fifth bridge than they did on the fourth. A yield buyer is about to capitalize growth in the payout, and it will credit only the growth the business has shown it can fund and keep going through its own capital structure.

Is the equity valued right?

The fifth bridge's valuation is built on the file that values the owners' cash, so the inspector reads that file closely. An independent model reviewer does most of it.

The reviewer starts with the reconciliation. The equity is computed two ways on the base case of the levered forecast: the owners' cash discounted at the relevered cost of equity, and the enterprise value less the debt. The two have to agree within a stated tolerance, with the gap explained by named sources, and a gap beyond the tolerance is recorded as a finding against the direct equity figure. For any month in which a facility was being drawn or refinanced, the enterprise route governs.

The cost of equity file relevers the sector's unlevered beta to the actual debt-to-equity at each recent quarter-end and, in the forecast, year by year as the debt amortizes, so each year's cash is discounted at that year's rate. The cost of debt comes from the executed facility, with the hedged and unhedged portions separated, and the weighted cost of capital moves only through the tax shield. No premium for size or for the business's particular risks appears in the rate, and no scenario risk is carried there either.

The competitor map is carried forward with every competitor still named, refreshed each quarter from the deals won and lost, and reconciled once a year to the lender's view of the industry. A stale map, or one missing a competitor the lender knows about, is a finding. The scenario file runs a rate shock, a covenant breach and a soft quarter through the levered forecast, and, while any guarantee or key-person clause remains, the owner's death or disability. The cost of each cure is charged to the owners, and each probability is drawn from the business's own record and from named base rates. The margin of safety is stated, with the reason it is wider than at the last anchor.

The price reversal log takes every recapitalization term sheet, sale indication and leveraged comparable the business has met, reverses it into what it implies, including the leverage at close, and places it against the band the checkpoint allows. The holder's inputs give the expected holding period as a range tied to the facility's tenor, the maturity ladder and typical fund holding periods, and name the guarantee release and the second lender's indication as inputs, so the inspector can recompute the discount for illiquidity from scratch.

Did the crossing pay?

The last line belongs to the owner. For each year since the facility closed, it takes the distributions actually paid plus the change in the reconciled equity value, divides by the opening equity value, and sets the result against that year's relevered cost of equity, year by year and cumulatively.

Beside it sits the history of distributions: what was paid each year, what could have been paid after the reserves the covenants and the growth line required, and the named policy or decision behind any gap. A cumulative return below the cost of equity is reported plainly, as a finding against the bridge. The line weighs more at this checkpoint than at any other. The fifth bridge is about making the payout reliable, and an owner deciding whether to cross it should first know what the last bridge actually paid.

Where a failure goes, and how a business slips

A business that fails a line goes back to the fourth bridge, to the first span whose measure it cannot show. Unreconciled packs or an incomplete schedule send it to the first span. A downside that does not clear its covenants, or growth the structure would cut, sends it to the second. A breach, a standing guarantee or unhedged rate exposure sends it to the third, and unseasoned debt or an unreconciled equity value to the fourth.

The ways a business slips off free cash flow to equity are the fourth bridge's disciplines lapsing. A covenant is breached, or leverage creeps past capacity. The finance function hollows out and the owner is back managing the bank, reporting to the lender runs late, and debt-like obligations pile up off the schedule. Floating-rate exposure goes unhedged, a maturity arrives without a committed refinancing, and the owner's guarantee comes back at renewal. On the growth side, spending becomes the first line cut to protect a covenant, the undrawn growth line lapses or is drawn for something else, and a basket is traded down at renewal for a lower rate. In the valuation file, the cost of equity is left unmoved while leverage changes, or relevered for the history and held flat across the forecast; 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 quietly folded into the required return. And the holder's return goes unmeasured while the debt is serviced, so nobody learns whether the crossing paid.

On the fifth bridge each of these reaches past the lender. With a yield buyer about to capitalize what is left after the debt, every one of them puts the payout at risk.