Unitranche Underwriting with Aggressive EBITDA Add-Backs
A direct lending fund is underwriting a $195m first-lien unitranche for Valeo Software, a sponsor-backed B2B SaaS business. Management reports $30m of adjusted EBITDA, including $8m of add-backs for one-off restructuring, capitalized R&D, and expected synergies from a tuck-in not yet closed. Pro forma leverage is 6.5x. Revenue is $95m, 70% recurring, net revenue retention 105%, but gross churn is 12% and the largest customer is 9% of revenue. The sponsor wants a $25m dividend recap at closing and has proposed covenant-lite terms with a 50% EBITDA grower basket. The fund's concentration limit is 10% of committed capital per borrower; the fund has $2bn committed and $300m of dry powder. The investment committee is concerned about add-back quality and the dividend recap. The company's cash balance is $12m and it has a $10m revolver.
1. Assess whether the $8m of add-backs should be accepted in the leverage calculation, and state the resulting leverage on a conservative basis.
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Treat the $8m as a quality-of-earnings issue, not a single negotiating number. Split it into components. Truly one-off restructuring costs that are already incurred and documented can be added back if they are non-recurring. Capitalized R&D normally should not be added back because it is a real operating investment. Expected synergies from an unclosed tuck-in should be excluded until the deal closes and the savings are realized.
On a conservative basis, deduct roughly $5m for unclosed synergies and capitalized R&D, giving $25m. Debt of $195m divided by $25m is 7.8x, not 6.5x. Even if $3m of cost savings are credible, $195m divided by $27m is 7.2x. That is high for a business with 12% gross churn, 105% net revenue retention, and 9% customer concentration. The IC should require a post-closing leverage cap of 6.5x on a defined EBITDA, a cap on add-backs at 15-20% of reported EBITDA, and a dollar-for-dollar equity cure. If the sponsor insists on all $8m, either reduce the debt size, reprice the spread, or defer the dividend recap until the add-backs are proven.
2. What protections would you require to mitigate the covenant-lite structure and the 50% EBITDA grower basket?
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Covenant-lite with a 50% EBITDA grower basket is dangerous here because it lets the borrower increase debt as EBITDA grows, including growth driven by add-backs, without a maintenance test. For a software business with 12% gross churn and customer concentration, the lender needs an early-warning mechanism, not only incurrence tests.
Require a springing maintenance covenant tested when revolver utilization exceeds 35% or liquidity falls below $15m. Cap EBITDA add-backs at 15% of reported EBITDA and put a sunset on synergy add-backs. Limit the grower basket to 25% of EBITDA growth and permit it only for acquisitions, not dividends or distributions. Add a minimum liquidity covenant, a most-favored-nation and anti-layering provision, monthly reporting, a 13-week cash-flow forecast, and limits on transferring intellectual property. The revolver should be lender-controlled, with a blocking right on dividends if liquidity is below a threshold. If the sponsor refuses all maintenance protection, price the risk with a wider spread or reduce the commitment rather than accept a structure that only works in the base case.
3. How should the fund respond to the $25m dividend recap and its own concentration limit?
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The dividend recap transfers value from lenders to the sponsor before the add-backs are proven. It should be capped or deferred. A 10% concentration limit on $2bn committed is $200m. A $195m hold uses 97.5% of that limit, leaving no room for follow-on, a second tranche, or another borrower in the same sector. That is too concentrated for a covenant-lite first-lien unitranche with customer concentration and churn risk.
Recommend reducing the hold to $150m and syndicating $45m, or bringing in a co-lender. If the fund keeps $195m, it needs a higher spread, a tighter grower basket, and a right to approve the dividend recap. Check dry powder: $300m cannot comfortably support a $195m position plus reserves. A $150m hold leaves $50m of the concentration limit and preserves diversification. Approve the dividend only if it is capped at 50% of the request and leverage on conservative EBITDA stays below 6.5x. Otherwise, require the sponsor to fund the recap with equity or delay it until the tuck-in closes and the savings are realized.