Covenants
Maintenance vs. incurrence covenants, covenant-lite trends, and lender protections
~15 min read
When a lender provides $300M to fund an LBO, the loan agreement does not simply say 'pay us back.' It includes a detailed set of operating restrictions and financial tests called covenants. Covenants are the lender's primary tool for monitoring credit quality and protecting against borrower behavior that could put repayment at risk. They function as early warning systems: if the company's financial health deteriorates or if the sponsor attempts to extract value in ways that weaken the lender's position, covenants are designed to trigger a conversation (or a confrontation) before the situation becomes a full-blown default.
Covenants fall into two broad categories. Affirmative covenants require the borrower to do something: maintain insurance, pay taxes, deliver quarterly financial statements, comply with laws. These are administrative in nature and rarely controversial. Negative covenants restrict the borrower from taking certain actions without lender consent: incurring additional debt, paying dividends, making acquisitions, selling assets, or changing the business. Negative covenants are where the real negotiation happens, and they vary dramatically depending on market conditions and the borrower's leverage.
Maintenance vs. Incurrence Covenants
The most important distinction in covenant structures is between maintenance and incurrence covenants. A maintenance covenant is tested on a regular schedule, typically every quarter, regardless of whether the borrower has taken any action. For example, a maintenance leverage covenant might require Net Debt / EBITDA to remain below 5.5x, tested at the end of each fiscal quarter. If EBITDA drops or debt rises and the ratio exceeds 5.5x, the borrower is in breach even if it did nothing to cause the deterioration.
An incurrence covenant is tested only when the borrower takes a specific action, such as issuing new debt, making an acquisition, or paying a dividend. The same leverage test (Net Debt / EBITDA below 5.5x) as an incurrence covenant would only be measured at the moment the borrower attempts to take on additional borrowings. If the company's leverage has drifted to 6.0x due to declining EBITDA but the borrower has not tried to incur new debt, no covenant is triggered. This distinction is fundamental. Maintenance covenants give lenders ongoing monitoring power. Incurrence covenants give borrowers more operating freedom but only constrain specific actions.
| Covenant | Maintenance | Incurrence | |
|---|---|---|---|
| Max leverage ratio (Net Debt / EBITDA) | Tested quarterly; breach if exceeded regardless of cause | Tested only when borrower takes on new debt or makes an acquisition | |
| Min interest coverage (EBITDA / Interest Expense) | Tested quarterly; ensures cash flow covers interest payments | Rarely used as incurrence-only; typically a maintenance test | |
| Min fixed charge coverage | Tested quarterly; measures cash flow vs. all fixed obligations | Sometimes used as a condition for restricted payments (dividends) | |
| Max capital expenditure | Annual cap tested at year-end | Not typically structured as incurrence |
The Rise of Covenant-Lite (Cov-Lite)
One of the most significant shifts in leveraged lending over the past decade has been the move toward covenant-lite (cov-lite) loan structures. A cov-lite loan eliminates maintenance financial covenants entirely, relying only on incurrence-based tests. The borrower has no obligation to meet periodic financial benchmarks; covenants are triggered only when the borrower takes a specific action like incurring additional debt.
Cov-lite loans were a small fraction of the market before 2013, accounting for roughly 15-20% of new leveraged loan issuance. By 2024, cov-lite loans represented over 90% of new institutional leveraged loan volume in the US (according to PitchBook LCD data). Several factors drove this shift:
- Abundant capital. Record inflows into leveraged loan funds, CLOs, and credit strategies created intense competition among lenders. Borrowers and sponsors used this leverage to negotiate away maintenance tests.
- Track record. Lenders observed that maintenance covenants often triggered technical defaults during temporary downturns, leading to costly amendment and waiver processes that did not necessarily improve credit outcomes.
- Institutional investor base. CLOs and mutual funds that hold Term Loan B instruments prefer the operational simplicity of cov-lite structures because managing covenant compliance across hundreds of portfolio positions is administratively burdensome.
Critics argue that cov-lite removes the early warning system that gives lenders a seat at the table before problems escalate. Without maintenance tests, the first sign of trouble may be a missed interest payment, by which point recovery values have already deteriorated. The counter-argument is that sophisticated lenders can monitor credit quality through other channels (monthly financials, market intelligence) without needing a covenant trigger to start a conversation.
What Happens When a Covenant Is Breached
A covenant breach does not automatically mean the company is in bankruptcy. It means the borrower is in technical default, which triggers a defined process:
- Notice. The borrower must notify the lender (or agent bank) of the breach, typically within 5-10 business days of discovering it.
- Standstill. During the cure period, the lender can typically block new draws on the revolver and halt the borrower from taking certain actions, but cannot immediately accelerate the loan (demand full repayment).
- Waiver or amendment. The most common outcome. The borrower negotiates with lenders to either waive the breach (forgive it for that period) or amend the covenant threshold going forward. Lenders typically charge a waiver fee (0.25-0.50% of the outstanding loan) and may tighten other terms.
- Acceleration. If no waiver or amendment is reached, the lender can declare a default and accelerate the loan, making the full balance due immediately. This is a last resort because it typically forces a restructuring or bankruptcy process that reduces recovery for everyone.
In practice, most covenant breaches are resolved through waivers and amendments. The breach gives lenders leverage to reprice the loan (wider spread), tighten other covenants, or extract fees. For the PE sponsor, a covenant breach often means an uncomfortable conversation but rarely leads directly to losing the company.
Cov-Lite in Practice: The Asda LBO (2021)
When the Issa brothers and TDR Capital acquired Asda (the UK supermarket chain) from Walmart in 2021, the financing package included approximately $4.8B in leveraged loans and bonds. The term loan was structured as covenant-lite, with no maintenance financial tests. The only financial covenants were incurrence-based, tested when the company sought to take on additional debt or make restricted payments.
As Asda's operating performance came under pressure from inflation and competitive dynamics in 2022-2023, leverage rose above initial projections. Under a traditional maintenance covenant structure, the company would likely have been in technical default, giving lenders a seat at the negotiating table. Under the cov-lite structure, no breach occurred because the company was not attempting to incur additional debt. Lenders could monitor the situation through secondary market loan pricing (which dropped to around 90 cents on the dollar at one point), but they had no contractual mechanism to force a conversation until a payment default or an incurrence trigger was pulled.
PitchBook LCD; Bloomberg reporting on Asda LBO financing
Quiz: Covenants
6 questions · ~3 min