As we all know, senior debt is at the head of the line when we talk about subordination. That is, if a company is wound up, senior debt lenders receive their pesos before most other lenders, and certainly before equity holders. Inherent in this concept, is that providers of debt are mostly concerned with risk rather than growth prospects. You may read from this that debt providers are typically bitter, cynical and pessimistic, and you’d mostly be correct.

If I may talk out of turn, debt providers don’t like much in life (certainly not cute puppies, walks on the beach or the dulcet tones of jazz), but they absolutely love debt covenants. It gives them a chance to apply a tight grip to their customers’ proverbials. As disparaging as this may sound, debt providers are the source of much value for private equity firms. With that tight grip in mind (and of course the team’s carry), we need to do everything we can to maintain healthy reports and measures against these Machiavellian covenants. 

There are three typical covenants used:

1. Debt/Earnings: this provides a multiple or value that suggests how many years of earnings will pay back the debt principal (this measure is also called the gearing ratio). The earnings number may be EBIT or EBITDA, depending on the preferences of the provider. A typical multiple for this covenant is between 2-4x, although for larger deals a multiple of 5x isn’t unusual.
2. Earnings/Interest: this provides a multiple that suggests how many times the current earnings could pay back the interest on the debt (also called interest cover ratio). The idea being that earnings could fall X% before the business couldn’t pay the interest on its debt. A typical multiple for this covenant is at least 2x, the higher the better. 
3. Cashflow/Repayment: this is similar to the interest cover ratio, except it uses free cash flow (FCF) in the numerator to bypass the obvious downfalls of using an accounting earnings number. It also adds the compulsory principal repayments to the denominator (so the denominator = interest + principal repayments). The reason for this is that the expected repayment often contains a principal component.

There are many other debt covenants in use around the world, but these three are typical in the US, EU and in Asia. Private equity firms, amongst other consumers of debt, report on these covenants quarterly, with a more detailed report expected upon the receipt of audited accounts.