Pricing
Margin ratchet
A margin ratchet moves your interest margin with performance, usually leverage. It is the one part of the pricing that can improve after signing, and the conditions attached to it decide whether it ever does.
Also called pricing grid · leverage grid · margin grid · pricing ratchet
A grid prices leverage in steps. Each band the business deleverages through takes another slice off the margin.
| Net leverage | Reduction from opening |
|---|---|
| Above 3.5x | 0bps |
| 3.0x to 3.5x | 25bps |
| 2.5x to 3.0x | 50bps |
| Below 2.5x | 75bps |
Illustrative grid expressed as movement from the opening margin. The guides publish no absolute ratchet levels, so none are asserted.
What a ratchet does
A margin ratchet ties the interest margin to a performance measure, almost always net leverage, through a grid of bands. As the business deleverages it moves down the grid and the margin falls; if leverage rises again the margin steps back up.
It is the only part of a facility's pricing that can improve without renegotiating, which is why it matters to a borrower planning to grow into cheaper debt. Everything else in the cost stack is fixed at signing: the arrangement fee is paid, the discount is taken, the exit fee is contracted. The margin is the one live number.
Ratchets are close to standard on bank facilities at £3-15m and appear less consistently on fund deals, where the pricing model depends more on a stable expected return.
How the grid is built
The grid sets a margin for each leverage band, usually three or four bands covering the range the business is expected to travel through. The opening margin corresponds to the leverage at close, and each band below it carries a reduction.
The step size matters as much as the number of bands. A grid with four bands and small steps rewards steady deleveraging; one with two bands and a large step rewards crossing a single threshold and does nothing in between. Where a business has a clear deleveraging plan, matching the band boundaries to the leverage the plan passes through is worth more than arguing about the step size.
Some facilities key the grid to something other than leverage: interest cover, or on occasion a sustainability or performance metric. Leverage remains the norm at this size because it is already tested, already defined, and already in the compliance certificate.
The saving is real but modest. On £5m, a full 75 basis point step-down is £37.5k a year.
| Step-down | Annual saving |
|---|---|
| 25 bps | £12.5k |
| 50 bps | £25k |
| 75 bps | £37.5k |
Illustrative annual saving on a fully drawn £5m facility at each step of the grid above. Derived arithmetic.
What a step-down is worth
Less than borrowers expect, which is the honest answer and a useful one at term-sheet stage.
On a fully drawn £5m facility, 25 basis points is £12,500 a year, 50 is £25,000 and a full 75 is £37,500. Those are real numbers but they are smaller than several of the fixed costs the same negotiation covers: an arrangement fee at fund convention on the same facility can be £125,000, taken once and immediately.
The practical consequence is about where to spend negotiating capital. A borrower who wins a sharper ratchet but concedes on the arrangement fee has usually lost. A borrower who wins on the fee and takes a standard grid has usually won, because the fee is certain and the ratchet is contingent on a deleveraging path that may not happen.
The conditions that block it
The grid is the easy part of the clause. The conditions attached decide whether it operates.
A subsisting event of default blocks any reduction, which is standard and reasonable. Delivery of the compliance certificate on time is usually required, which rarely causes a problem. A minimum period between steps prevents a business from ratcheting down twice in consecutive quarters on a temporary improvement.
The condition that costs the most is a first-year holiday: no reduction is available until the first anniversary regardless of performance. On a business that deleverages quickly after an acquisition, that can mean paying the opening margin through the year the improvement occurred. Where a deleveraging plan is credible, asking for the ratchet to be available from the first test date after the initial period is a reasonable request and is worth more than a sharper grid with a holiday attached.
When the change takes effect
This is a timing detail with a real cost attached and it is settled in the drafting.
The ratchet is tested on the same quarterly cycle as the covenants, on a trailing twelve-month basis, and the result is reported in the compliance certificate. But the reduced margin usually applies from delivery of that certificate rather than from the test date it reports on. With a certificate window of thirty to sixty days, that gap means a borrower who crossed a band boundary at the quarter end keeps paying the higher margin for up to two more months.
Some facilities apply the change retrospectively to the test date, with a true-up. That is worth asking for, costs the lender little on a step-down, and is easier to obtain than a change to the grid itself. It cuts both ways, of course: a step-up would also apply retrospectively.
The grid is the easy part. The conditions around it decide whether the step-down ever arrives.
| Condition | How often it bites |
|---|---|
| Certificate delivered on time | Rarely |
| Minimum gap between steps | 25–50 on the scale |
| No subsisting default | Standard |
| First-year holiday | Costs the most |
Market convention at £3-15m. Individual facilities vary.
What else moves with the margin
The ratchet reaches further into the facility than the interest line, and whether it does depends on drafting rather than intent.
The commitment fee on any undrawn amount runs at around 35% of the applicable margin by market convention. Where the drafting says applicable margin, a step-down reduces the commitment fee too. Where it fixes the fee at the opening margin, it does not, and a business with a large undrawn revolving line loses part of the benefit it earned.
Default interest is usually expressed as an uplift on the applicable margin, so it moves as well. On a facility with a PIK element the split between cash and PIK is sometimes tied to the margin, though more often it is fixed. Reading which of these say applicable and which say opening takes ten minutes and occasionally finds real money.
The ratchet upwards
Grids are symmetrical. A business whose leverage rises back through a band pays more, and that mechanism operates without any breach having occurred.
It is worth modelling because the step-up arrives at the least convenient moment. Leverage rising usually means either debt increasing, most often to fund an acquisition, or earnings falling. In the first case the increase is a known cost of the transaction and should be in the model. In the second, the business is paying more for its debt at exactly the point its cash is tightest, which compounds the pressure on the cover tests.
Where a facility funds a bolt-on that will temporarily raise leverage before the acquired earnings annualise, ask how the grid treats the acquisition. Pro forma treatment for the ratchet, mirroring how the covenant annualises acquired EBITDA, prevents a mechanical step-up during the integration period.
What to negotiate
Four things, in rough order of value.
Removing or shortening a first-year holiday, which is where most of the lost benefit sits. Applying the change from the test date rather than from certificate delivery. Tying the commitment fee to the applicable margin rather than the opening margin. And pro forma treatment of acquisitions so an integration does not trigger a mechanical step-up.
The grid itself moves least, because it is the part the lender modelled the return on. That is fine: the grid is also worth the least. A standard grid with clean conditions beats a generous grid a borrower can never reach.
Common questions
What is a margin ratchet?
A grid tying the interest margin to a performance measure, almost always net leverage. As the business deleverages it moves down the grid and the margin falls; if leverage rises the margin steps back up. It is the only part of a facility's pricing that can improve without renegotiating.
How much can a margin ratchet save me?
On a fully drawn £5m facility, 25 basis points is £12,500 a year, 50 is £25,000 and a full 75 is £37,500. Real money, but smaller than several fixed costs in the same negotiation: an arrangement fee at fund convention on the same facility can be £125,000, taken once and immediately.
Why has my margin not stepped down?
Usually a condition rather than the grid. Common blockers are a first-year holiday preventing any reduction until the first anniversary, a subsisting event of default, a minimum period between steps, or a compliance certificate delivered late. The first-year holiday is the one that most often costs a fast-deleveraging borrower real money.
When does the lower margin start applying?
Usually from delivery of the compliance certificate rather than from the test date it reports on. With a certificate window of thirty to sixty days, that means paying the higher margin for up to two months after you crossed the band. Asking for the change to apply from the test date with a true-up is a reasonable request and easier to win than a change to the grid.
Does the ratchet affect my commitment fee?
Only if the drafting says so. The commitment fee runs at around 35% of the applicable margin by market convention, so where the clause refers to the applicable margin a step-down reduces it too. Where it fixes the fee at the opening margin it does not, and a business with a large undrawn line loses part of the benefit it earned.
Can my margin go up as well as down?
Yes. Grids are symmetrical, and a step-up operates without any breach having occurred. It usually arrives at the worst moment, because leverage rises either when debt increases for an acquisition or when earnings fall, and in the second case you pay more for debt exactly when cash is tightest.
Will an acquisition push my margin up?
It can, mechanically, if debt lands before the acquired earnings annualise. Ask how the grid treats acquisitions, and for pro forma treatment mirroring the way the covenant annualises acquired EBITDA. That prevents a step-up during the integration period, which is when the business least needs one.
Should I negotiate the grid or the conditions?
The conditions. The grid is the part the lender modelled its return on, so it moves least, and it is also worth the least in cash. A standard grid with clean conditions beats a generous grid you can never reach because a first-year holiday blocks the only step-down you were going to earn.
The full treatment sits in the guide: all in cost of debt.
This page explains a term as it is used in the UK lower-mid-market. It is general information, not advice on any particular facility. Terms vary between lenders and between deals, and the drafting in your own agreement governs.