Different lenders underwrite acquisition financing a little differently; however, they all typically want to stay under 6 x EBITDA on leverage. The reasoning is fairly simple…cash flow. As we’ll see below, agencies don’t cash flow well when they leverage themselves over about 6 x EBITDA. One of lenders’ key underwriting metrics is something called the debt coverage ratio, which is a measure of the cash flow cushion over debt payments. Mathematically, it looks like this:
A debt coverage under 100% means there is insufficient pre-tax cash flow to cover the debt payments. Most lenders typically look to see a coverage of 125% or more, as should buyers, since the calculation does not factor in income taxes and since the agency’s revenue could drop unexpectedly over the course of the loan.
Let’s look at some numbers. The chart below shows debt coverage ratios based on two variables. The first variable is the total debt as a multiple of EBITDA (left column) going from 4 x EBITDA up to 8 x. The second variable is the length of financing going from 5 years out to 10 years, which is the standard range. The calculations were made using a 7% interest rate and assuming principal and interest payments are made. Quite noticeably, the chart demonstrates why a 6 x EBITDA leverage cap exists.
Allow me to put this in terms of dollars by way of an example. Let’s say you are looking at acquiring an agency with a $1M EBITDA, which we’ll assume is after paying all operating expenses and paying you a fair compensation for doing the work of running the agency. On a 33% EBITDA margin, this would equate to an agency with roughly $3M of revenue. When we crunch the numbers on this deal, we see negative cash flow on most of the terms and tight cash flow on those with leverage in the 5-6 x EBITDA range, further illustrating why lenders use 5.5 to 6.0 x as a cap.
So you might ask how is it that agencies are selling for 7+ times EBITDA? The key is that I’m talking about leverage not price. Paying 7+ times EBITDA is not the same as being leveraged at 7 x EBITDA. An example is one agency with no debt acquiring another one at 7 x EBITDA. The leverage post-merger will be less than the purchase price. Also, and probably more importantly, private equity buyers borrow interest-only debt. Eliminating the requirement to repay principal annually cuts the debt service roughly in half and thereby allows you to pay 50% more for an acquisition.
If you follow Insurance Journal closely, you may have seen an article recently about one of the decade’s most active acquirers being in a tough financial position. In fact, Moody’s has downgraded the broker’s credit rating to ‘Caa1’ and the S&P Global Ratings downgraded them to a ‘CCC’, both of which being high-risk credit ratings. The reviews highlighted that the broker’s (loan) covenant cushion remains very tight and its first-lien credit facility may accelerate the maturity of the debt this year. I’ve read the Moody’s reports on other large brokers and this one, sitting at a leverage of 8 x EBITDA, was the highest I’ve seen. Private equity backed buyers push the leverage ratio over 6 x by using interest-only debt but even that can become a dangerous game if revenues deteriorate or interest rates increase.
Hopefully, you have a little better understanding of debt coverage ratio limits after reading this. Next time I’ll get into cash flow projections, factoring in debt and taxes.