Study 5: Interest Coverage

The approximate 500 bps increase in base rates since mid-2022 has increased the borrowing costs for middle-market companies whose primary funding source is floating-rate loans. The interest coverage ratio (which we define as adjusted EBITDA divided by total interest expense) can be used as an indicator of stress, and lenders often require an interest coverage ratio covenant to protect their loan. In the private lending market, there is low visibility in this ratio. In our proprietary database of performing private loans that comprise our Private Performing Credit Index (PPCI), we can measure the impact of rising rates on private credit borrowers.

Average interest coverage peaked at 3.5x in Q4 2021 near the end of the extended low-rate cycle, fell to 1.7x by Q1 2023, and continued to decline slightly since then to 1.6x. The percent of the PPCI population with a ratio less than 1.5x increased from 7% to 53% over that same period.  

Methodology

Each quarter, Houlihan Lokey captures private credit loan information, including the amount of debt and corresponding interest rates. This information is adjusted as appropriate to calculate each borrowers’ interest coverage ratio. Adjustments may include pro forma adjustments to EBITDA, annualization of quarterly interest expense, and estimation of interest expense when there is limited information.

We have calculated both a simple average of all the ratios of the borrowers and a weighted average applying the same outstanding balance weights as the PPCI. We have observed that the difference between these two averages implies that companies with larger EBITDA have generally experienced a larger shift toward lower coverage ratios. They may also have been underwritten at tighter interest coverage ratios than smaller borrowers. We also calculated the distribution of interest coverage ratios in total and by industry. We explore those in the following sections.

Distribution of Borrowers by Interest Coverage Ratio  

In the histograms below, we show the distribution of borrowers by ratio after eliminating a small number of outlier results. In the period from the end of the low interest rates at the end of 2020 to the current high interest rates, the clustering of borrower interest coverage ratios became much tighter around the 1.0–1.5x range, from a much broader range of 1.5–4.0x.  

Perhaps most interesting are the borrowers whose interest coverage ratios are currently less than 1.5x. This set of borrowers increased substantially from 7% to 53% of the population between Q4 ’20 and Q2 ’24 as shown below:

Breakdown of Interest Coverage Ratios by Industry

The results were highly varied across industries. We segregate the population by the nine industries. For the most recent quarter, Energy and Other have the lowest average ratios, and Real Estate, Lodging, and Leisure has the highest.

A Perspective on Changes Relative to Size of Company

In our PPCI Study 1: How Do Yields Vary by Size of Borrower?, we examined the yields for borrowers clustered by EBITDA to represent company size. The analysis below extends that clustering by EBITDA to the distribution of results for the two time periods discussed above (end of low-rate cycle and current). The histogram below shows that the distribution of interest coverage ratios remained fairly broad in smaller companies but became very tightly clustered in larger companies.

A Look to the Future

The interest rate market gives us a view of the future of rates. The SOFR forward curve indicates that the base rate, 90-day term SOFR, is expected to fall from current levels. We calculated the implied average and weighted average interest coverage ratios based on the forward rate for mid-year 2025 and mid-year 2026 while keeping adjusted EBITDA unchanged.

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