Why is interest coverage (or the fixed-charge cover ratio) often the binding constraint on LBO leverage rather than the leverage multiple itself?
An advanced Private Equity question — expect it in final rounds and case-heavy interviews (IB, PE, Big-4 Transaction Services).
THE SHORT ANSWER
Leverage multiples (debt/EBITDA) tell you how much debt the structure carries, but the business has to actually service that debt in cash — so the binding constraint is frequently cash coverage: EBITDA (or EBITDA less capex) relative to cash interest and fixed charges. When rates are high, the same leverage multiple costs far more in cash interest, so a company that could carry 6x at low rates might only sustain 4.5x before coverage gets too thin to survive a downturn. Lenders set both leverage and coverage covenants; coverage is what protects against default because a business defaults when it can't pay, not when a ratio looks high. So in sizing the debt I'd test the FCCR/interest cover through a downside case, not just the headline multiple — and in a high-rate environment the affordable debt (and hence the price) is compressed by coverage long before the leverage ceiling bites.
WHAT INTERVIEWERS LISTEN FOR
- ✓Leverage multiple ≠ ability to service debt in cash
- ✓Coverage (EBITDA/cash interest, FCCR) is what prevents default
- ✓High rates raise cash interest, tightening coverage at the same multiple
- ✓Size debt off downside coverage, not just headline leverage
COMMON MISTAKES
- ✗Sizing debt only on leverage multiple
- ✗Ignoring cash interest/coverage in a high-rate world
- ✗Not stress-testing coverage in a downside
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