Margin ratchet
LBOA pricing grid stepping the loan margin down as leverage falls, so the cost of the debt drops as the borrower delevers.
Also written: pricing grid, margin grid
A margin ratchet ties the interest margin to a financial ratio, almost always net leverage, tested on the same schedule as the compliance certificate. Cross a threshold downward and the margin steps down at the next payment date. Cross it upward and the margin steps back.
It exists because a deleveraging borrower is a different credit from the one the lender originally underwrote. Repricing that improvement automatically is cheaper for both sides than negotiating an amendment, and it removes some of the borrower's incentive to refinance the loan away the moment its credit improves.
For the returns bridge this matters in a way candidates rarely mention. Deleveraging is normally described as converting enterprise value into equity value. With a ratchet it does something else as well: it cuts the price of the debt that remains, so free cash flow rises, which sweeps more principal, which triggers the next step down. The two effects compound over a hold.
The steps are typically small and the mechanism is not always symmetric. Some grids have a floor below which the margin cannot fall, and many are suspended entirely while a default is continuing, which is the point at which a borrower would most like the relief.
Worked example
An illustrative grid on 250 of debt: 4.00% above 5.0x net leverage, 3.75% between 4.5x and 5.0x, 3.50% between 4.0x and 4.5x.
Each 25 basis point step is worth 0.625 a year on 250 of debt. Two steps down over a hold is 1.25 a year of cash the business keeps.
That cash sweeps to principal, which pulls leverage down faster, which brings the next step forward. Small numbers, but they run in the same direction as the deleveraging itself rather than against it.