Hi, it's CJ Gustafson and welcome to Looking for Leverage, the top newsletter for PE backed finance leaders.

Today's term: the excess cash flow sweep. This is the clause in your credit agreement that decides how much of the cash your business generates actually stays in your business, and how much gets sent to your lenders before you get a vote.

A friend of mine is the CFO at a sponsor-backed company, and a couple of Januarys ago he closed the books on a solid year. Cash was up (and he knew it was going to be up). So he'd already built the next year's operating plan around it: two more sales pods, a warehouse expansion the company had deferred for years, and a little cushion so he could stop refreshing the revolver balance like a maniac every Friday afternoon.

Then his controller dropped an annoying google comment into the year-end debt review: based on the audited numbers, they owed a mandatory prepayment to the term loan lenders that spring (a few months after year-end close).

"Excess cash flow sweep" were three words he was aware, but not thinking of. Def filed under “mechanical, deal with it later." And that later had arrived, and it wanted about two million dollars of the cash he'd already spent two times over in his head.

You know what a mandatory prepayment is. The credit agreement lists events that force you to pay down the term loan ahead of schedule:

The last one is the excess cash flow sweep. Each year you calculate a defined cash number, multiply it by a percentage, and wire that to your lenders on top of your scheduled amortization. While the mechanic isn't terribly hard to understand (it’s actually pretty simple math), it's admittedly hard to factor into your day to day cash generating life as a portco CFO. It’s more in the background than it probably should be, lurking, and ready to hoover up your extra success.

Three things turn this from a line in the credit agreement into a constraint on your operating plan.

First, "excess cash flow" is a defined term, not your cash flow statement. It's a build, and it lives in the definitions section of your credit agreement. Roughly, it starts at Adjusted EBITDA (the credit agreement version, which we discussed in a previous issue) and subtracts the cash you need to run the biz:

What's left is the cash the lenders consider "excess," meaning available to pay them down faster than the schedule requires.

Second, the sweep percentage steps down as you de-lever. A typical grid is tied to your first lien net leverage:

The more you pay down, the smaller the share of next year's cash the lenders take. That step-down is a legitimate incentive, and yet it doesn't get modeled that often within the operating plan like you’d model your headcount forecast.

Third, the timing works against your planning calendar. The sweep is measured on the full prior year, and the payment comes due a short window after you deliver your annual financials to the lenders. But those financials are themselves due 90 to 120 days after year-end. For a December year-end, the bill lands in spring, usually April or May. A strong Q4 you couldn't fully see until it was banked shows up as a cash demand a few months later, often the same stretch you're funding merit increases and the seasonal working capital build.

Put the three together and the operating problem is this: the cash you generated by operating well doesn't stay in the business for you to reinvest (even if that was your plan). A chunk of it leaves, and because the sweep is a percentage of cash generated, the better your year, the bigger the check. So you can beat your plan and end up with less discretionary cash than you forecast, because beating the plan fed the number that gets swept.

The one lever sitting in the definition is capex. It's usually deducted in the build, so money you spend on the business reduces excess cash flow dollar for dollar and never gets swept.

This is the biggest advice I have on the topic: Whether your agreement deducts actual capex it changes the whole calculus of when to spend. You can play with this lever.

Say you run a $100M revenue company with $20M of Adjusted EBITDA and an $80M term loan at close (4.0x leverage). Your excess cash flow build for the year:

Your first lien net leverage at the test date is 4.1x, which puts you in the top bracket: a 75% sweep.

Now the operating lever. Capex is deducted in the build. The $3.0M you spent already reduced excess cash flow by $3.0M, keeping $2.25M out of the lenders' hands at a 75% sweep. If you'd deferred $1.0M of that capex into next year, excess cash flow would have been $1.0M higher and $750K of it would have been swept.

Deferring a project past year-end can hand three-quarters of its cost straight to the lenders. So if you've got capex you were going to spend anyway, the sweep is a reason to pull it forward across year-end rather than let the cash sit and get taken. Maybe you even spend a bit more?

Oh, and the step-down is worth real money too. De-lever into the 3.0x to 4.0x band and the sweep on this same $5.7M drops to $2.85M. Get below 2.5x and it's zero.

Back to my friend. The spring payment stung, but the part that changed how he ran the place came a week later, when he went back to the warehouse expansion he'd kept deferring. He'd been treating the sweep as a tax on cash. Once he read the definition closely and saw it deducted actual capex, he started treating it as a set of operating incentives he could plan around.

The warehouse math flipped on him. Spending on it before year-end reduced excess cash flow, which meant the lenders effectively co-funded three-quarters of it at the company's 75% sweep rate. The alternative was to defer it, watch the cash get swept, and pay for the warehouse out of next year's tighter budget anyway. It was the same project, and the only difference was whether he spent the cash before the lenders did.

That's when he stopped budgeting the operating plan and the debt paydown as two separate exercises. Every dollar of forecast free cash flow has three places it can go (reinvest it, prepay debt with it, or let it get swept), and the credit agreement already has a strong opinion about which. So best to also have your own.

Wishing you an excess cash flow definition with generous deductions and a step-down you actually reach this year,

CJ

Looking for Leverage breaks down one PE term, clause, or mechanic each week, written for the CFOs and finance leaders who actually have to live with these things. If this got forwarded to you, subscribe at lookingforleverage.com. If there's a term you want broken down, reply and tell me. I read everything.

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