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FRM Part II · FRM Exam Part II · Private Markets Investing

A risk manager reviews a direct lending fund whose loans have covenant-lite terms and a 60% weighted-average loan-to-value at origination. Sponsors have been using EBITDA add-backs of 25% of reported EBITDA. Reported leverage is 5.0x debt/adjusted EBITDA. Reported EBITDA before add-backs is the basis for the adjusted figure, which equals reported plus add-backs. What is the leverage on unadjusted EBITDA, and what is its implication?

Leverage on unadjusted EBITDA is 6.25x, because adjusted EBITDA is 1.25 times reported, so debt over reported EBITDA is 5.0 times 1.25. Covenant-lite terms mean lenders lack maintenance tests to intervene early, so true risk exceeds the headline figure.

  1. A5.0x; add-backs have no effect on leverage
  2. B4.0x; actual leverage is lower so risk is overstated
  3. C6.25x; actual leverage is higher, and weak covenants limit lender's early intervention rightsCorrect
  4. D6.0x; actual leverage is higher but covenants give strong protection

Explanation

Adjusted EBITDA = 1.25 x reported, so debt/reported = 5.0 x 1.25 = 6.25x. Cov-lite terms mean there are no maintenance tests to trigger early lender action, so underlying leverage and recovery risk are higher than headline.

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