Seasoning

Lenders call debt that has been through a hard time and been paid seasoned. A seasoned loan has a history: a downturn in the borrower's business, a refinancing or a rise in rates, and payment on schedule anyway. A loan that has only seen good months has no history in this sense, however long it has been outstanding, and nothing yet shows whether it would survive a bad one.

An equity buyer cares about this as much as a lender does. The buyer of a leveraged business is buying the residual behind the debt, and the residual is what absorbs a bad quarter. If the debt has never been through one, the buyer has no evidence about what happens to the residual when it comes, and will assume the worst.

Seasoning is the driver that creates the evidence. It moves free cash flow to equity by proving that levered cash flow survives stress: debt serviced on schedule through a soft quarter or a refinancing, without a breach and without the owner's money, so that the equity is priced on cash that has been tested.

A soft quarter, carried

The record the driver needs is debt serviced on schedule through at least one soft quarter, or through one refinancing, with no covenant breached and no money injected by the owner to cure one, and a seasoning memo that records the period.

A soft quarter has a mechanical definition: revenue fell by a set margin below the average of the four quarters before it. The owner's sense of a difficult time does not count. Anyone can check the definition from the statements, which is why a credit committee will accept it. In the illustration, a quarter with $2.6 million of revenue against a trailing average of $3 million sits 13.3 percent below it, 3.3 points past the illustration's margin.

The finance lead tests every quarter since the facility closed against that definition, and the first that qualifies is the seasoning event. If none does, because the business has been fortunate, a planned refinancing serves instead. Refinancing the facility on the business's own record is a different kind of stress, and it proves the same thing.

The memo is short and written for a credit committee. It gives the period and the figures, the covenant tests for each month with their headroom, and the actions taken from the action list with their dates. It also confirms from the bank statements that no owner funds entered the business during the period, and a buyer reads that line most carefully. A breach cured with the owner's money was still a breach, paid for privately, and it shows the business could not carry its own debt. A clean memo is what lets a buyer stop discounting for durability.

The owners' cash, every month

The lender pack also shows free cash flow to equity every month, with interest after tax, principal repaid and net new borrowing each on its own line, reconciled to the statements.

The pack already walks from free cash flow to the firm to cash flow available for debt service. The walk now continues through debt service and net borrowing to free cash flow to equity, with each line taken from the debt schedule or the ledger.

Reported monthly, the figure makes borrowing visible as a choice. A draw on a line to fund a purchase appears as net new borrowing that month, and the owners' cash rises by it. An early repayment appears too, and the owners' cash falls by it. Either can be right, and once the owners and the board see both every month they can govern them. A buyer reading the figure month after month, reconciled to the statements, has little left to verify about where the owners' cash came from.

Why a handled bad quarter is the most valuable record

Owners sometimes find this hard to believe: a business with eight good quarters since closing has a weaker record than one with seven good quarters and one bad one it handled well.

A lender or a buyer reading the record is trying to answer one question, which is what will happen in the next bad quarter, and eight good quarters cannot answer it. One bad quarter, handled, answers it directly. The memo shows the forecast seeing the dip coming, the trigger reached, the action list started, coverage falling and recovering, and the debt paid without help. Without the memo, a credit committee would have to guess at every one of those facts.

No business should go looking for a bad quarter. When one comes, as it will, recording it properly is some of the most valuable work the finance seat does that year.

Using the record at the first review

The memo's first reader is usually the business's own lender, at the facility's first annual review.

At closing, the lender set covenants and terms for a borrower it had not yet seen through a bad quarter, and priced that uncertainty into the structure. A year later, with a memo showing a soft quarter carried without a breach or the owner's money, the uncertainty is smaller and the structure can be argued again. The finance lead can ask for a covenant reset to wider headroom, the removal of a covenant that springs into force under conditions now shown not to matter, or a pause in repayments during a seasonal trough. A second lender's indication, from Lender Relationships, makes the request credible.

A margin reduction is easier to win. It saves money, but it leaves the next soft quarter exactly as dangerous as the last, so the record is better spent on terms that change the structure.

What it does to value

Seasoning ranks ninth on the bridge. It ranks so low because most of what the seasoned record does is reveal. It lowers the breach probability a lender or buyer assigns, but only because the evidence has improved; the structure is unchanged, and so is the risk. That verification effect is not counted as value. Neither is the removal of a buyer's haircut for an unseasoned structure, the wider pool of leveraged buyers a seasoned record attracts, or the permission to value the owners' cash directly, which the seasoned record earns as its second condition.

What is counted is narrower: the fall in breach probability caused by the structural terms the record wins at review, meaning the covenant reset, the release of a springing covenant and the repayment pause that lowers fixed charges in a soft quarter. Those change the risk itself, and each is negotiated on the strength of the record. So the seat paid for this driver is rewarded half for the coverage record and half for a structural term actually won, and nothing for a margin reduction alone.

Owner funds injected to cure a covenant are deducted from equity value at their full amount.

What has to be in place first

The memo cites the monthly covenant tests from Covenant Management, without which the period cannot be shown to have been clean. It uses the debt schedule from Facility Close, which says what was due and when. And it shows the action list from Covenant Management in use, which is the evidence that the business acted on a plan.

Knowing that it works

The finance lead keeps a cumulative count of quarters of debt service on schedule since closing, the lowest coverage in any quarter since closing against the floor, and owner funds injected, in dollars, where the target is none.

The owner should be able to tell the story of the soft quarter from the memo, without the finance lead, in the order a credit committee would ask: what fell, what was done, what the tests showed. And the owner should confirm from the bank statements, not from memory, that no personal money entered the business during the period.

Why it slips, and what holds it

The next soft quarter can still end in a breach if what worked in the last one was not kept. The actions that carried it become the standing playbook, folded into the action list, so the next one is handled faster.

The other risk is the finance function hollowing out, so that the record of how the business carried its debt leaves with the person who wrote it and the owner is back managing the bank. The finance lead writes the memo and keeps it current, which keeps the record with the finance seat instead of in the owner's memory.