How Much Debt Can an LBO Support? Why the Cash-Flow Coverage Test, Not the Headline Leverage Multiple, Sets the Real Ceiling — and Why Higher Rates Cut Buyout Leverage Even Though Lenders’ Appetite Barely Moved

Two Constraints Set the Ceiling, and the Lower One Always Wins

Ask how much debt a buyout can carry and the reflexive answer is a leverage multiple — “six times EBITDA.” That is half the answer, and usually the wrong half. Lenders underwrite against two separate tests, and the debt a deal can actually raise is capped by whichever one produces the smaller number. The first is the leverage test: total debt expressed as a multiple of EBITDA, the number that appears in credit committee memos and league tables. The second is the coverage test: whether the business generates enough cash to pay the interest and mandatory amortisation on that debt without breaching a covenant in a down year.

The two tests answer different questions. Leverage asks how much a lender is willing to advance against a given stream of earnings; coverage asks whether the borrower can actually keep the debt current. In a benign rate environment the two roughly coincide and the leverage cap binds, so sponsors push debt to the multiple the market quotes. The moment the cost of that debt rises, the tests diverge — and the coverage test starts binding well below the leverage the market would otherwise offer. Understanding which constraint is live is the difference between a candidate who quotes a multiple and one who understands how the number is set.

Leverage: The Total Debt Is Built Tranche by Tranche off EBITDA

The leverage cap is assembled, not quoted as a single figure. Lenders size each layer of the debt stack to its own multiple of EBITDA and stack them: senior secured term debt at, roughly, 4.0–4.5x in a strong market, then a second-lien or subordinated layer on top, producing total leverage of around 5.5–6.5x for a healthy, non-cyclical business. Each tranche prices to its risk — senior debt cheapest, junior debt dearest — and the blend of the stack determines the all-in cost that the coverage test then has to absorb. The mechanics of how that stack is filled and where the money goes run through the sources and uses.

What the leverage test does not do is check affordability. A lender that will advance 6x against a stable earnings base will advance the same 6x whether the reference rate is 1% or 6% — the multiple reflects recovery risk in a default, not the cost of carrying the debt while the business is healthy. That is precisely why the leverage number alone is a trap: it is a statement about how much lenders will lend, not about how much the business can pay. The second test supplies the missing half.

Coverage: Higher Rates Shrink What the Same Business Can Carry

The coverage test measures cash flow against debt service. The simplest form is interest coverage — EBITDA divided by cash interest — and lenders and sponsors typically want that comfortably above roughly 2.0x at close, so a normal downturn does not push it toward the 1.0x line where the business cannot pay its interest. A fuller version, the fixed-charge coverage ratio, nets capex and tax out of EBITDA and divides by interest plus mandatory amortisation, capturing the reality that a capital-intensive business has less spare cash to service debt than its EBITDA implies.

Because coverage is EBITDA over interest, and interest is the debt balance times the all-in rate, the rate environment moves this test directly while leaving the leverage test untouched. Take a business with £100M of EBITDA. In a 2021-style market with an all-in cost of debt around 5%, 6x leverage means £600M of debt costing £30M of interest — coverage of 3.3x, comfortably inside the constraint, so the leverage cap binds and the sponsor takes the full 6x. Re-run the same business in a 2023-style market where the all-in cost is closer to 10%: that same £600M now costs £60M of interest, coverage falls to 1.7x, below the floor lenders will accept. To restore ~2x coverage the debt has to fall to around £500M — 5.0x, not 6.0x — even though the lender’s stated appetite never changed.

This is the single most useful thing to understand about debt capacity: the leverage multiple and the coverage ratio are not two ways of saying the same thing. When rates are low they agree and the multiple looks like the whole story; when rates rise, coverage is the constraint that actually sets the number, and the quoted multiple becomes a ceiling the deal never reaches.

What Actually Moves the Number: Cash-Flow Quality, Not the Multiple

Two businesses with identical EBITDA can support very different debt loads, because the coverage test is about serviceable cash, not accounting earnings. The variables that matter are the ones that sit between EBITDA and the cash available for debt service: free-cash-flow conversion, capex intensity, working-capital swings, and the cyclicality of the revenue. A business that converts 90% of EBITDA into free cash flow has far more room to carry interest than one that reinvests half of it in capex just to stand still.

This is why asset classes lever so differently. A software business with recurring revenue, negative working capital and minimal capex can be pushed to the top of the leverage range and beyond, because its cash flow is both high-converting and predictable enough to keep coverage intact through a soft patch. A cyclical manufacturer at the same EBITDA carries less, because a downturn hits its earnings and its coverage at the same moment — and lenders size the debt to survive that trough, not the peak. The headline multiple is a market convention; the real ceiling is set by how much of the EBITDA reaches the interest line and how stable it is when the cycle turns.

Maximum Debt Is Rarely the Debt a Sponsor Should Raise

Even where the tests permit it, the most debt a deal can carry is not the amount a disciplined sponsor takes. Leverage magnifies returns on the way up and losses on the way down, and a business run at the absolute coverage limit has no headroom: one bad quarter pushes it toward a covenant breach, at which point the lenders, not the sponsor, hold the negotiating leverage. That is why deals leave a cushion below the maximum — and why the covenant package, not just the leverage multiple, governs how close to the edge a sponsor can operate.

Where that cushion sits depends on the covenants themselves. A covenant-lite structure with no maintenance test lets a sponsor run closer to the limit without a quarterly breach; a tighter package with a leverage or coverage covenant forces more headroom and, sometimes, an equity cure right so the sponsor can inject cash to fix a breach rather than hand over control. The debt a deal can raise is a lending question answered by the two tests above; the debt it should raise is a risk question answered by how much room the sponsor wants between the business and a bad year. The two are related, but they are not the same number — and knowing why is worth more in an interview than reciting a leverage multiple.