The Covenant Headroom Squeeze
Ridgeline Manufacturing has a term loan with two maintenance covenants tested quarterly: (1) Total Debt / EBITDA ≤ 3.5×, and (2) Fixed Charge Coverage Ratio (FCCR) ≥ 1.25×. Last quarter: Total Debt $70M, EBITDA $21M (leverage 3.33×), FCCR 1.30×. Management forecasts next year: EBITDA will fall to $19M because a major customer is insourcing, while the company plans a $6M debt-funded capex expansion. Interest expense is ~$4.5M/year and scheduled principal is $3.0M/year. The company argues the covenant test should exclude the new capex debt as 'growth capital' and that EBITDA should be adjusted upward for one-time items.
1. Project the covenant metrics under management's plan (ignore the requested adjustments first) and assess headroom.
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Leverage: New debt $70M + $6M = $76M; EBITDA $19M → 76/19 = 4.0×, breaching the 3.5× covenant. Even before the new debt, 70/19 = 3.68× - already over the limit on falling EBITDA alone.
FCCR (approx.): (EBITDA − capex) / (interest + scheduled principal). Using maintenance capex only (the $6M is the expansion, debt-funded but still consumes cash):
- Numerator ≈ $19M − (some capex). Even at zero capex, $19M / ($4.5M + $3.0M) = 19/7.5 = 2.53× - looks fine.
- But if the $6M expansion capex is treated as a fixed charge: (19 − 6)/7.5 = 1.73×, still above 1.25× but with less cushion than headline.
Headroom: Leverage is the binding constraint and is already breached or near-breach on the EBITDA decline alone; the debt-funded capex pushes it to 4.0×, a clear default trigger. FCCR has room but deteriorates if capex is counted. The plan is not financeable as structured.
2. Evaluate management's requested adjustments and recommend a path that preserves the relationship without waiving the covenants outright.
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On the adjustments:
- Excluding growth capex debt from leverage is not standard - lenders size total debt against total EBITDA regardless of purpose. Reject as a permanent change; at most allow a temporary step-up.
- EBITDA add-backs for 'one-time' items must be scrutinized: a lost customer is a permanent revenue loss, not a one-time charge. Adding it back would flatter the metric and mask a structural decline. Reject recurring 'one-time' items.
Recommended path:
- Don't waive - amend. Grant a temporary leverage step-up (e.g., to 4.25× for two quarters) with a step-down schedule, in exchange for consideration (fee, margin increase, or equity cure).
- Defer or resize the $6M capex until the customer transition is absorbed, or fund it with equity/subordinated capital that doesn't hit senior leverage.
- Require a deleveraging plan - e.g., suspend distributions, apply free cash flow to debt.
- Tighten monitoring to monthly, with a liquidity covenant added.
This preserves the relationship, keeps the lender protected, and forces management to confront the structural EBITDA decline rather than redefining it away.