Key takeaways
- A maintenance covenant is tested every period; an incurrence covenant only when the borrower takes an action. Private credit loans usually carry at least one maintenance test.
- The definitions decide whether a covenant bites: an EBITDA definition with generous add-backs can make a tight-looking ratio loose.
- Measure headroom as how far EBITDA can fall before a breach, then compare it with your downside case.
Why covenants matter
A loan's interest rate is what the lender earns if things go well. Its covenants are what protect the lender if they don't. They are promises the borrower makes in the credit agreement: to do certain things, not to do others, and to keep its financial position within agreed limits. When a promise is broken, the lender gets a seat at the table before the problem becomes a loss.
A credit agreement can run to hundreds of pages. You don't need to read it front to back on a first pass. You need to know where the protection is and whether it will work in your downside case.
Three kinds of covenant
- Affirmative covenants: things the borrower must do, such as deliver financial statements on time, maintain insurance, pay taxes and keep its assets in good order. The reporting covenants matter most: they are how you see trouble coming.
- Negative covenants: things the borrower must not do without permission, such as take on more debt, grant liens to other lenders, pay dividends, make large investments or sell key assets. Each usually comes with exceptions called baskets.
- Financial covenants: limits on ratios such as maximum leverage, minimum interest or fixed charge coverage, or minimum liquidity.
Maintenance vs. incurrence
A maintenance covenant is tested on a schedule, typically every quarter, whatever the borrower does. If leverage drifts above the limit because earnings fall, that is a breach. An incurrence covenant is tested only when the borrower takes a specific action, such as borrowing more or paying a dividend; it limits what the company can choose to do, not what can happen to it.
A loan with no maintenance covenant on its term loan is called 'covenant-lite'. Direct loans usually keep at least one maintenance test, which is a large part of why a direct lender can act early.
Definitions do the real work
A leverage covenant is only as strict as the definitions of debt and EBITDA behind it. Start with the definition of EBITDA. What can be added back: restructuring costs, projected cost savings ('run-rate' synergies), one-off expenses? Is there a cap on those add-backs, for example as a percentage of EBITDA, and a time limit for savings to be realised? Then read the definition of debt: does it count all borrowings, or net off cash, and if so, how much?
“A tight ratio over a loose definition is a loose covenant. Read the definitions before you read the number.”
Headroom: how far can earnings fall?
Headroom is the cushion between where the borrower is today and where it would breach. The most useful way to express it is the fall in EBITDA that would trip the covenant, because you can compare that directly with your downside case.
| Item | Value |
|---|---|
| Covenant debt | $450m |
| Covenant EBITDA (last twelve months) | $100m |
| Leverage today | 4.5x |
| Maximum leverage covenant | 5.5x |
| EBITDA at which the covenant is breached ($450m ÷ 5.5) | $81.8m |
| Headroom: fall in EBITDA before a breach | ≈ 18% |
Illustrative example, not a real borrower. If your downside case cuts EBITDA by more than about 18%, the covenant trips in that case.
Check whether the covenant tightens over time (a step-down schedule) and whether debt will rise, for example from a delayed-draw term loan, before it does. Headroom that looks comfortable at closing can disappear a year later.
Leakage and cures
Negative covenants come with baskets: permitted amounts of extra debt, dividends or investments. Generous baskets, especially ones that grow with earnings or retained cash, let value leave the borrower's credit group, away from the lender's collateral. Add up the major baskets and ask how much could leave without your consent.
Finally, look for an equity cure: the sponsor's right to inject equity that counts as EBITDA (or reduces debt) to fix a breach. It buys time, which can be useful, but check how many times it can be used and whether the cash has to stay in the business.
A first-pass checklist
- List every financial covenant, its level and its test dates.
- Read the EBITDA and debt definitions; note add-backs and any caps.
- Compute headroom as the EBITDA decline to breach, at closing and after any step-downs or planned borrowing.
- Total the main debt, dividend and investment baskets.
- Note cure rights, reporting deadlines and what counts as an event of default.
- Compare all of it with your downside case. If the covenant trips only after you're impaired, it isn't protection.
Keep going
- Case: Copperline HVAC Services: a $150M buyout loan and a $40M add-on facilityMembers · Foundational · Direct lending
- Case: Northfield PackagingMembers · Intermediate · Direct lending
- Guide: Private credit and direct lendingMembers
- Guide: How to build the credit modelMembers
- Glossary: covenant termsMembers
Educational content; not investment advice. Figures in exhibits are illustrative unless a source is given.