Module IV· Debt TranchesAdvanced
Question
What is a 'Margin Ratchet' and how does it work on term loans?
Answer
Mechanics
A margin ratchet = a coupon linked to the leverage ratio. As leverage falls, the margin falls (step-down). As leverage rises, the margin rises (step-up).
Deep diveShow more details
Example structure (standard middle-market)
| Senior Debt / EBITDA | Margin (over SOFR) |
|---|---|
| > 5.0x | SOFR + 475bps |
| 4.5x − 5.0x | SOFR + 425bps (Initial) |
| 4.0x − 4.5x | SOFR + 400bps |
| 3.5x − 4.0x | SOFR + 375bps |
| < 3.5x | SOFR + 350bps |
Consequence
The sponsor has an incentive to deleverage quickly — each 0.5x of EBITDA reduction cuts the coupon by 25bps. Over 5 years and $200m of debt = $2.5m cumulative savings.
Common pitfalls
- Modeling: the margin must be an IF formula, not hardcoded
- Test dates are typically quarter-ends (Q1, Q2, Q3, Q4) — interim improved leverage does not trigger immediately
- The step-up on re-leveraging (e.g. a recap) is often forgotten — it can ruin uneconomic recap plans
Pitch tip
Question: "How much is the ratchet worth in IRR?"
Answer: "Typically 100-150bps of IRR improvement over a 5-year hold, because the margin reduction frees up cash for sweep or distribution. The step-down is not symbolism but a material IRR lever"