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FRM Part II · FRM Exam Part II · The Global Drivers of Private Credit

A sponsor-owned company has USD 400 million debt and EBITDA of USD 80 million (5.0x leverage), with a 10% floating rate. The sponsor proposes a dividend recapitalization financed by new private credit of USD 80 million at the same 10% rate. EBITDA is unchanged. After the recap, what are leverage and interest coverage, and what is the key risk implication?

Debt rises to USD 480 million, giving 6.0x leverage, and interest rises to USD 48 million, cutting coverage from 2.0x to 1.67x. The dividend goes to the sponsor, not the business, so lenders bear higher default risk with no added earnings.

  1. A6.0x leverage and 1.67x coverage; the sponsor extracts equity while the firm's default risk risesCorrect
  2. B5.0x leverage and 2.0x coverage; no change in risk
  3. C6.0x leverage and 2.0x coverage; risk is unchanged since coverage is stable
  4. D4.0x leverage and 1.67x coverage; risk falls

Explanation

New debt = 480 million; leverage = 480/80 = 6.0x. Interest = 48 million; coverage = 80/48 = 1.67x, down from 80/40 = 2.0x. Proceeds go to the sponsor as a dividend, not to the business, so credit risk increases. The 2.0x figure is the pre-recap coverage.

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