Credit Analysis

Designing Financial Covenants: Maintenance vs Incurrence

Financial covenants are contractual tests that give lenders early warning and negotiating leverage before a borrower runs out of cash. Maintenance covenants are tested every period regardless of borrower action, while incurrence covenants are tested only when the borrower takes a specified action. Good design sets cushions to a realistic base case, defines terms tightly and limits cures.

What is the purpose of a financial covenant?

A financial covenant is not a prediction that the borrower will fail. It is a tripwire that hands the lender a seat at the table when performance moves meaningfully away from the plan that justified the loan. When a covenant is breached, the lender gains the right to declare a default, which in practice usually leads to a negotiated amendment, a fee, tighter terms, additional equity or a paydown. The covenant's job is to trigger that conversation early enough that real options remain, while the business still has liquidity and enterprise value well above the debt.

How do maintenance and incurrence covenants differ?

Maintenance covenants are tested on a fixed schedule, usually quarterly on a trailing twelve month basis, whether or not the borrower does anything. Common examples are maximum total leverage, maximum senior leverage, minimum fixed charge coverage, minimum interest coverage, minimum liquidity and maximum capital expenditure. Because they test ongoing performance, they give the lender the earliest warning. Bank loans and most middle market private credit facilities rely on maintenance tests, and the compliance certificate delivered with each quarterly package becomes the lender's routine checkpoint on whether the original thesis still holds.

Incurrence covenants are tested only when the borrower wants to take an action such as raising additional debt, paying a dividend, making an acquisition or granting new liens. If the borrower cannot meet the ratio on a pro forma basis, it simply cannot take the action. A borrower whose earnings deteriorate does not default under an incurrence covenant; it just loses flexibility. High yield bonds and many large syndicated loans described as covenant lite rely mostly on incurrence tests, which shifts monitoring risk to the lender and pushes problems later into the credit's life.

• Maintenance: tested periodically, early warning, standard for banks and direct lenders
• Incurrence: tested on specified actions, preserves borrower flexibility, common in bonds
• Springing: a maintenance test that applies only when a condition is met, such as revolver usage above a threshold

How should covenant cushions be set?

The cushion is the distance between the borrower's projected performance and the covenant level. It is usually expressed as the percentage decline in EBITDA that would cause a breach. A cushion that is too tight produces technical defaults on normal volatility and wastes everyone's time on amendments. A cushion that is too loose means the lender only gets a voice once the borrower is already in serious trouble. Many lenders set initial cushions in the range of roughly 25% to 35% below the sponsor or management case, then tighten step downs over time to track expected deleveraging.

The right cushion depends on the earnings volatility of the business rather than a market convention. An analyst can look at the historical peak to trough decline in EBITDA, the sensitivity to the largest customer, and the downside case in the model. If the downside case shows a 30% decline, a covenant set with only a 20% cushion will trip in that scenario, which is often exactly what the lender wants: a reset of terms before the downside fully plays out.

Why do covenant definitions matter so much?

The covenant ratio is only as strong as the definitions behind it. Consolidated EBITDA in a modern credit agreement can include addbacks for restructuring costs, projected cost synergies, run rate savings, pro forma acquisitions and nonrecurring charges. Uncapped addbacks can inflate covenant EBITDA well above cash earnings, which quietly widens the cushion the lender believed it had. Lenders should cap synergy and cost savings addbacks as a percentage of EBITDA, require that they be realized within a set period, and define debt to include capital leases, seller notes, earnouts once earned and other debt like obligations.

How do equity cures work?

An equity cure lets the sponsor or owner contribute new equity after a covenant breach and count it toward the test as if it were EBITDA, or apply it to reduce debt, so the borrower is deemed in compliance. Cures are borrower friendly but reasonable when limited. Typical protections include a cap on the number of cures over the life of the loan, a limit on consecutive quarters, a requirement that the cure amount not exceed the shortfall, and a rule that cured EBITDA does not count for pricing grids or permitted payments.

From the lender's perspective, an equity cure is useful evidence: an owner willing to inject cash is signaling confidence and taking first loss. Problems arise when cures become routine and mask a structural decline. If a borrower needs to cure two quarters in a row, the lender should assume the base case is broken and require a deeper look at the business rather than accepting another check as a substitute for performance. A second cure is a good moment to request a refreshed forecast, a lender call with management and, where appropriate, an independent review of liquidity.

How should step downs and testing periods be structured?

Most leverage covenants step down over the life of the loan, reflecting the expectation that the borrower will repay debt and grow earnings. Step downs should follow the deleveraging path in the lender's own base case rather than the sponsor's more aggressive plan, and they should keep roughly the same percentage cushion each year. Testing usually begins at the end of the first full fiscal quarter after closing, though some agreements allow a holiday of several quarters for acquisitions or turnarounds. Seasonal businesses may need covenants tested on a trailing basis that captures the full annual cycle, so a strong or weak quarter does not distort the result.

Which covenants fit which kinds of borrowers?

Covenant packages should match how the borrower creates and loses value. Asset light, recurring revenue businesses may be measured on leverage or on a minimum liquidity and revenue test if EBITDA is not yet meaningful. Capital intensive companies need fixed charge coverage so that capex and cash taxes are captured. Asset based loans often use a springing fixed charge test that applies only when excess availability falls below a threshold. Real estate loans use debt service coverage and debt yield tests with cash sweep triggers. The best package is short, tied directly to repayment risk, and easy to calculate from the reporting the borrower already produces.

Setting a leverage covenant and sizing an equity cure

1. Closing debt is $100,000,000 and base case EBITDA is $25,000,000, so opening leverage is $100,000,000 / $25,000,000 = 4.0x.
2. Target a 30% EBITDA cushion: $25,000,000 x (1 - 0.30) = $17,500,000. Covenant leverage = $100,000,000 / $17,500,000 = 5.71x, rounded to a 5.75x maximum.
3. Trailing EBITDA later falls to $17,000,000. Leverage = $100,000,000 / $17,000,000 = 5.88x, which breaches the 5.75x test.
4. EBITDA cure: compliance requires EBITDA of $100,000,000 / 5.75 = $17,391,304, so the sponsor must contribute $17,391,304 - $17,000,000 = $391,304 if the cure is counted as EBITDA.
5. Debt paydown cure: compliance requires debt of $17,000,000 x 5.75 = $97,750,000, so the cure would need to repay $100,000,000 - $97,750,000 = $2,250,000. The gap shows why lenders care which cure method the agreement allows.

How underwriters apply this

• Set the cushion from the borrower's own downside case and historical volatility, not from a market rule of thumb.
• Read the EBITDA and debt definitions as carefully as the ratio levels; that is where cushion is gained or lost.
• Cap addbacks for synergies and cost savings and require realization within a defined window.
• Limit equity cures by number, frequency and amount, and exclude cured amounts from pricing and payment baskets.
• Prefer maintenance tests when the lender cannot easily exit, and recognize that incurrence only structures defer warning signs.
• Make sure every covenant can be calculated from reporting the borrower is required to deliver.

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Educational content written by practitioners. Not investment, accounting, legal or tax advice.