Two covenants that look independent at closing fail five basis points apart — and the one the chapter never runs in the downside is the one that goes first.
A unitranche is underwritten at 6.25 times leverage. The base case returns a fixed charge coverage ratio of 1.70; the downside — a -12% revenue decline with margins at 17% — returns 1.15. Thin, the chapter says, but still above 1.00, and no covenant is breached. Both figures are right. What neither of them says is how far the assumptions can move before they stop being right, and the answer turns out to be 79 basis points of margin.
Worked in full in The Private Credit Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The downside is reported as a coverage ratio, and the coverage covenant is 1.10, so the conclusion follows: 1.15 clears it. But this deal has two covenants, and the second one is never run in the downside. Set it out and it changes the reading.
| Case | Revenue, year 1 | Margin | Coverage | Leverage | Verdict |
|---|---|---|---|---|---|
| Base | 6% | 22% | 1.70 | 5.69× | no breach |
| Downside | -12% | 17% | 1.15 | 9.04× | no breach |
| Stress | -20% | 15% | 0.93 | 11.34× | breach |
In the downside the coverage ratio falls from 1.70 to 1.15 — it has used 92% of its headroom. Leverage rises from 5.69 to 9.04 against a 9.5 covenant, using 88% of its own. Two tests that look independent at closing — one with 55 per cent of headroom, the other with more than three turns of cushion — are consumed at almost exactly the same rate by the same scenario.
Hold revenue at the downside level and walk the margin down. The coverage covenant fails at a margin of 16.16%. The leverage covenant fails at 16.21% — before it, by 5 basis points of margin.
| Year-1 margin | EBITDA | Coverage | vs 1.10 | Leverage | vs 9.5× |
|---|---|---|---|---|---|
| 22.00% | 19.36 | 1.448 | pass | 6.90 | pass |
| 20.00% | 17.60 | 1.329 | pass | 7.63 | pass |
| 18.00% | 15.84 | 1.210 | pass | 8.52 | pass |
| 17.00% | 14.96 | 1.150 | pass | 9.04 | pass |
| 16.50% | 14.52 | 1.120 | pass | 9.33 | pass |
| 16.16% | 14.22 | 1.100 | fail | 9.53 | fail |
| 15.00% | 13.20 | 1.021 | fail | 10.30 | fail |
The ordering is the same from the other direction. Hold the margin at 17% and walk revenue down instead: leverage fails at a decline of -16.1%, coverage at -16.7%. Whichever way the credit deteriorates, the leverage test is reached first — and it is the test the chapter reports no number for.
The more useful way to say it: the two covenants are 5 basis points of margin apart in scenario space. A structure with a coverage covenant and a leverage covenant that fail within five basis points of each other does not have two covenants. It has one test, written twice, and the second one buys no independent protection at all. That is worth knowing before conceding one of them in negotiation on the grounds that the other still holds.
Everything above collapses to a single figure. Between the downside case and the first covenant failure there is 0.69 of EBITDA — 4.6% of the downside EBITDA of 14.96. That is the entire margin for error the deal has left once an ordinary bad year has happened. Not the 0.05 of coverage headroom the ratio suggests: 4.6% of the earnings.
Which is what makes the panel the workbook adds at the bottom of the case sheet more than a formality. It asks which parts of the business are seasoned, and which of the unseasoned ones have been stressed separately — and it flags any that have not with a line that reads “this is the hole in the downside case”. The hole can now be sized.
Suppose a share of the earnings comes from something recently acquired or recently launched — a unit with nine months of history — and the downside applied the group assumptions to it uniformly, because that is what a single set of case assumptions does. How far does that piece alone have to miss before the whole credit fails a covenant? The book states neither the size of such a piece nor the decline it would suffer, so what follows is a threshold rather than a forecast: read down to your own share.
| Unseasoned share of EBITDA | Shortfall on that piece alone that breaches | In other words |
|---|---|---|
| 5% | 92.4% | essentially the whole piece |
| 10% | 46.2% | about half of it |
| 15% | 30.8% | about a third of it |
| 20% | 23.1% | about a quarter of it |
| 30% | 15.4% | about a sixth of it |
| 40% | 11.5% | about a ninth of it |
A unit worth 15% of EBITDA needs to underperform the group downside by 30.8% to take the whole credit through a covenant. Nine months of operating history is precisely the situation in which a third is an ordinary outcome rather than a tail one — and the group downside, built on the legacy churn rate, will not show it. That is the mechanism behind the case the chapter describes, priced.
The stress case — a -20% decline with margins at 15% — returns coverage of 0.93 and leverage of 11.34 times. It fails both tests, and it fails the cash test too: the business no longer covers its fixed charges. A downside that clears 1.00 tells you the deal survives an ordinary bad year. It does not tell you the distance to the next one, and here that distance is 4.6% of EBITDA.
Run the leverage covenant in every case, not only at closing, and report which covenant fails first — if the answer is “both, at the same point”, say so, because the committee is being shown two protections and owns one. Express the remaining cushion as a percentage of downside EBITDA rather than as turns or as a ratio difference, because that is the unit in which a single business line can consume it. And list the unseasoned EBITDA separately with its own case: at 4.6% of the total or more, it can break the credit by itself while every group assumption holds.
None of that requires a more sophisticated model. It requires running the one that exists in both directions, and reporting the smaller of the two answers.
This article is one calculation from The Private Credit Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
Get the book on Amazon →Free companion files
Also on Amazon UK · Amazon Germany · Amazon France · Amazon Canada
Reading guide: credit, private credit and distressed debt → · All 1706 articles →
If this book helped — or didn’t — a few lines on Amazon are worth more than they look: they are what the next reader goes on. Write a review. The workbook stays free either way.