Glossary
Loan Covenants
Loan covenants are promises a borrower makes in a loan agreement to take, or avoid, certain actions and to maintain specified financial conditions. Financial covenants such as minimum DSCR or maximum leverage give lenders early warning and the right to intervene if the borrower's credit deteriorates before a payment is missed.
Example
A credit agreement sets a maximum total leverage of 3.50x and a minimum fixed charge coverage of 1.25x. A company with $40,000,000 of debt and $12,000,000 of EBITDA has leverage of 3.33x and is compliant. If EBITDA falls to $11,000,000, leverage rises to 3.64x, a breach. To cure by repaying debt, the company would need to reduce debt to $38,500,000, a $1,500,000 paydown.
How it is used in underwriting
Covenants come in three main types. Affirmative covenants require actions, such as delivering financial statements, maintaining insurance and paying taxes. Negative covenants restrict actions, such as taking on more debt, selling assets, paying dividends or making acquisitions without consent. Financial covenants require ratios to stay within limits, for example maximum debt to EBITDA, minimum DSCR or fixed charge coverage, minimum liquidity or maximum capital expenditures. Underwriters set covenant levels with a cushion, often a set percentage below the projected case, so normal volatility does not trigger a breach but a real deterioration does.
Covenant definitions matter more than the headline ratio. EBITDA definitions may include add-backs that make compliance easier, and test periods, equity cure rights and step-downs change how tight a covenant really is. Covenant-lite loans, common in large syndicated deals, have few or no maintenance tests, giving lenders less early warning. Real estate loans more often use cash management triggers, such as a DSCR or debt yield level that sweeps excess cash to the lender, rather than outright defaults. A breach usually leads to negotiation, waivers and amendment fees rather than immediate acceleration.
Frequently asked questions
What are the most common financial covenants?
Common financial covenants include maximum total or senior leverage (debt to EBITDA), minimum fixed charge coverage or DSCR, minimum interest coverage, minimum liquidity or net worth, and maximum capital expenditures. Real estate loans often use DSCR and debt yield tests linked to cash management or reserve requirements.
What happens if you breach a loan covenant?
A covenant breach is typically an event of default that gives the lender rights to accelerate the loan, raise the interest rate or exercise remedies. In practice, lenders usually negotiate a waiver or amendment, often with a fee, a higher rate, tighter terms or an equity contribution, rather than calling the loan immediately.
What is an equity cure?
An equity cure lets a borrower's owners contribute cash that is counted as EBITDA or used to repay debt so a financial covenant breach is fixed. Credit agreements typically limit how often cures can be used and how much can be added, to prevent owners from masking an ongoing deterioration.
Related terms
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