CREDIT RATIO 1. Fixed charge coverage ratio: >1.

1x

= EBIT + Lease Payments Interest Expenses + Lease Payments + Sinking Fund Payments ( 1 Tax Rate )

Measure of firms ability to satisfy fixed financing expenses e.g. lease, interest. If high, then likelihood of bankruptcy is low cos annual earning is greater than annual interest obligation used to determine firms debt capacity & firms bond rating 2. EBITDA/interest coverage ratio = EBITDA/ interest payment >2.0x To screen if newly restructured co. can service short term debt obligation Cons: limited by relevance using EBITDA as proxy for financial figures If >1 then co. has enough interest coverage to pay off interest expense but may not be necessarily so cos may need to spend a large portion of profit to replace old equipment. Also EBITDA doesnt account for depreciation related expense, hence the ratio might not be a definite indicator of financial durability 3. (EBITDA-capex)/interest payment >1.4x Similar as above but subtract capex so its closer to FCF 4. senior debt/EBITDA <2.0-4.0x 5. total debt/EBITDA <4.0-6.0x Minimum equity requirement 25-35% Maintenance covenant financial std that borrower required to maintain e.g. need to maintain a certain ratio of EBITDA/total debt - used as early warning system to detect if borrowers earning are deteriorating and cant meet debt service requirement. Maybe maintenance covenant not needed if earning cycle is predictable But if gone then you can rely only on incurrence covenant requires borrowers to meet financial std not on regular basis but only in specific event e.g. meet specific EBITDA coverage test after acquisition Bullet amortization amortization all at once Senior secured debt VS unsecured debt Senior secured debt: 1st ranking, half bullet half amortising, flexible prepayment facility, maintenance covenant, longer maturity 6-9 years floating interest

Unsecured debt: 2nd ranking, fully amortising, flexible prepayment facility, less rigorous maintenance, shorter maturity 1-5 years, floating interest Bond prepayment risk Prepayment is early repayment of a loan by a borrower. In the case of a mortgage-backed security (MBS), prepayment is perceived as a risk, because mortgage debts are often paid off early in order to incur lower total interest payments through cheaper refinancing. The new financing may be cheaper because the borrower's credit rating has improved or because interest rates are lower, but in either case, the payments that would have been made to the MBS investor would be above market rates. Redeeming such loans early through prepayment reduces the upside of credit & interest rate variance in an MBS. As these variances head lower (interest rates rises or creditworthiness declines) borrowers lose the incentive to refinance (since the fixed mortgage payments are now at below-market rates). The fact that MBS-holders are exposed to downside prepayment risk, but rarely benefit from it, means that these bonds must pay a slightly higher interest rate than similar bonds without prepayment risk, to be attractive investments. (This is the Option Adjusted Spread.) To compensate for the prepayment risk (which is a reinvestment risk), prepayment penalty clause is often included into the loan contract.[1] There are often soft prepayment terms versus hard prepayment terms. Soft prepayment terms can allow you prepayment without penalty under the terms of selling the home. Hard prepayment does not allow any exceptions without penalty. Bond issuers can overcome prepayment risks by issuing what are called super sinker bonds. Super sinker bonds are a bond with long-term coupons but a short-term maturity. Super sinkers are usually home-financing bonds that give bondholders their principal back right away if homeowners prepay their mortgages. In other words, mortgage prepayments are used to retire a specified maturity. Super sinkers are likely to be paid off in a relatively short time. As a result, holders may receive the higher long-term yield after only a short period. What Does Prepayment Risk Mean? The risk associated with the early unscheduled return of principal on a fixed-income security. Some fixed-income securities, such as mortgage-backed securities, have embedded call options which may be exercised by the issuer, or in the case of a mortgage-backed security, the borrower. The yield-to-maturity of such securities cannot be known for certain at the time of purchase since the cash flows are not known. When principal is returned early, future interest payments will not be paid on that part of the principal. If the bond was purchased at a premium (a price greater than 100) the bonds yield will be less than what was estimated at the time of purchase.

Investopedia explains Prepayment Risk For a bond with an embedded call option, the higher a bonds interest rate relative to current interest rates, the higher the prepayment risk. For example, on a mortgage-backed security, the higher the interest rate relative to current interest rates, the higher the probability that the underlying mortgages will be refinanced. Investors who pay a premium for a callable bond with a high interest rate take on prepayment risk. In addition to being highly correlated with falling interest rates, mortgage prepayments are highly correlated with rising home values, as rising home values provide incentive for borrowers to trade up in homes or use cash-out refinances, both leading to mortgage prepayments. prepayment risk The risk to a lender that part or all of the principal of a loan will be paid prior to the scheduled maturity. For a bondholder, prepayment risk refers to the possibility the issuer will redeem a callable bond prior to maturity. Prepayments generally occur when market rates of interest decline following the loan origination. Prepayment generally results in reduced cash flow for a bondholder when proceeds from the redemption are reinvested at a reduced interest rate. Also called call risk. The risk that a borrower will repay a loan before its maturity, depriving the lender of future interest payments. Prepayment risk is most important for callable bonds, in which the issuer may repay the principal and cease paying coupons after a certain date, and mortgage-backed securities, in which the mortgage holder may refinance his/her mortgage, which will result in the security holder losing future interest. Some callable bonds and mortgage-backed securities have structures embedded within them to reduce prepayment risk. See also: Collateralized mortgage obligation, Yield-to-worst, Yield-tomaturity.

Loan Covenants: Out of Date or Out of Fashion?

Posted on May 20, 2007 by Geoffrey Parnass It's hard to ignore the growth of covenant-lite lending in private equity deals, when even famous investment gurus like Anthony Bolton remark on it, and at his farewell dinner no less. Here is what Mr. Bolton had to say on the topic: I think the phrase is covenant-lite, but in many cases it appears to mean no covenant at all, Mr Bolton said. He added: Covenant-lite borrowing ... will come back at some stage to haunt the banks, he said. Quotes about covenant-lite lending are usually paired with a dire prediction, such as the premonition of another financial bubble. But will covenant-lite lending really come back to haunt the banks?

In a typical covenant-lite deal, the lenders give up what are called "maintenance" covenants. As the name suggests, these are requirements that the borrower maintain certain financial standards at regular intervals. For example, a borrower might be required to certify that at the end of each quarter, it has maintained a certain ratio of EBITDA to total debt. These covenants are designed to be an early warning system that the borrower's earnings are deteriorating, and it might become unable to meet debt service requirements at some time in the future. With these maintenance covenants gone, the lenders rely solely on what are called "incurrence" covenants. These require that a borrower meet defined financial standards not on a regular basis, but only when there is a specific event, such as an acquisition. For example, if the borrower wants to make an acquisition, it must certify that it will meet a specific EDITDA coverage test after the acquisition is taken into account. Finally, in covenant-lite deals, the other covenants are less restrictive, for example allowing for more extensive dividend payments or larger capital expenditures. How bad are covenant-lite loans? Despite the publicity these deals receive, they appear to be limited to large private equity deals involving companies with earnings cycles that are relatively well known or at least fairly predictable. With companies like these, perhaps the function of maintenance covenants -- to provide an early warning system -isn't necessary. What good is a warning when the funds have already been loaned? Perhaps maintenance covenants aren't really needed, and their elimination is simply a matter of efficiency. Perhaps the traditional way of lending, where a borrower is required to certify periodically that it remains healthy enough to maintain its debt, is out of date. Then again, if it is merely out of fashion, we may see it come round again. Time will tell. http://www.privateequitylawreview.com/tags/maintenance-covenants/ role of financial sponsor tailor capital structure to account for seasonality, cyclicality, volatility of business/ to satisfy growth/WC requirement effect of transaction on financial leverage, at closing and over the term of debt that Fitch rates history of sponsor in previous transactions to determine if sponsors role in transaction source of initial equity/control the cos development after investment