What is a covenant?
A covenant is a formal promise written into an agreement that requires a party to take (or refrain from) certain actions. In commercial contracts you most often see covenants in lending and bond documents to protect creditors; in real estate they control how land is used; in religion they describe solemn commitments between people and the divine. Across contexts, covenants limit or obligate behavior to reduce uncertainty and protect interests.
Core definitions
– Affirmative covenant: a clause that obliges the borrower or contracting party to do something (for example, carry insurance or deliver audited financial reports).
– Negative covenant (restrictive covenant): a clause that forbids certain actions (for example, restricting dividend payments or additional borrowing without consent).
– Financial covenant: a rule expressed as a number or ratio that the borrower must meet (for example, a minimum interest coverage ratio). Financial covenants are often monitored regularly and can be expressed as either maintenance covenants or incurrence covenants.
– Maintenance covenant: a financial requirement that must be satisfied on an ongoing basis (typically tested quarterly or annually).
– Incurrence covenant: a financial test applied when the borrower takes a specific action (for example, when it seeks to issue more debt or make a large acquisition).
– Property covenant: a restriction or obligation that applies to real estate (examples include HOA rules or limits on the use or number of animals). Some property covenants “run with the land,” meaning they bind future owners.
Why lenders use covenants
Lenders add covenants to reduce credit risk by limiting borrower behavior that could weaken the borrower’s ability to repay. Covenants can:
– Protect creditor repayment prospects (e.g., stop excessive leverage or dividend payouts).
– Force timely disclosure (e.g., audited statements).
– Preserve collateral value (e.g., maintenance of insured status or asset upkeep).
Borrowers can sometimes negotiate modifications or waivers to negative covenants if the lender agrees.
Consequences of breaching a covenant
A breach (violation) typically gives creditors remedies such as:
– Declaring a default and accelerating repayment (demanding immediate payment of principal and interest).
– Requiring the borrower to cure the breach within a specified grace period (if the contract allows).
– Seeking other contractual remedies: higher interest, additional collateral, or halting certain activities.
Real estate covenant breaches can result in enforcement actions, fines, or court orders requiring compliance.
Common examples of covenants
– Affirmative: maintain insurance, file audited financial statements, comply with laws, keep accurate books.
– Negative: do not pay dividends above a cap, do not incur liens, do not undertake mergers without consent.
– Financial: maintain interest coverage ratio above X, keep debt-to-equity below Y, maintain minimum working capital.
– Property: trimming trees to a specified height, limiting types of uses or animals, parking restrictions.
How to evaluate a covenant — quick checklist
1. Identify type: affirmative, negative, financial, or property.
2. Read the measurement: what ratio or number is tested, and how is it calculated?
3. Check testing frequency and measurement timing (quarterly, annually, look-back periods).
4. Note cure periods and waiver provisions: is there a grace period or right to cure?
5. Look for carve-outs and exceptions (projects, permitted indebtedness, consolidated adjustments).
6. Understand consequences: acceleration, penalties, or other remedies.
7. Consider enforcement risk: how likely is the lender to enforce based on its own incentives?
8. If applicable, confirm whether covenants “run with the land” (property covenants binding future owners).
9. Monitor compliance: set calendar reminders for tests and reporting obligations.
10. Plan contingency actions: what steps to take if you anticipate a breach (seek waiver, renegotiate, or restructure).
Worked example — interest coverage covenant
Situation: A loan agreement requires an interest coverage ratio (ICR) of at least 3.0 on a trailing 12-month basis. ICR = EBITDA / Interest expense.
Company figures (trailing 12 months)
– EBITDA = $12 million
– Interest expense = $4 million
Calculate ICR:
ICR = 12,000,000 / 4,000,000 = 3.0
Interpretation:
– The company meets the covenant exactly (ICR = 3.0). A small drop in EBITDA or a rise in interest expense could cause a breach.
– If EBITDA falls to $11 million and interest stays $4 million: ICR = 11 / 4 = 2.75 → breach, unless the agreement allows a cure or the lender waives it.
Example of an incurrence covenant application
Suppose the company wants to take on new debt. The incurrence covenant requires that, after the new debt, pro forma debt-to-EBITDA must not exceed 4.0. Current debt = $30 million; EBITDA = $12 million; proposed new debt = $10 million. Pro forma debt = 40 million, so pro forma ratio = 40 / 12 ≈ 3.33 → incurrence allowed because 3.33 < 4.0.
Practical steps after identifying a restrictive covenant that may be tight
– Model scenarios to see when tests would fail.
– Talk to lenders early to request waivers or amendments before a breach occurs.
– Consider non-borrowing strategies: equity injection, asset sales, or covenant-compliant restructures.
– Maintain timely, transparent reporting to avoid disputes over calculations.
Things to remember
– Financial covenants can be framed as “must maintain” (maintenance) or “must satisfy when taking actions” (incurrence). Both constrain behavior but are enforced differently.
– Covenants can apply to lenders as well; borrowers sometimes negotiate protections against lender insolvency or operational risk.
– Property covenants may bind future owners and can be enforced by other homeowners or entities designated in the document.
Sources
– Investopedia — Covenant: https://www.investopedia.com/terms/c/covenant.asp
– U.S. Securities and Exchange Commission (Investor.gov) — Bonds and Bond Basics: https://www.investor.gov/introduction-investing/investing-basics/investment-products/bonds
– Corporate Finance Institute (CFI) — Loan Covenants: https://corporatefinanceinstitute.com/resources/knowledge/finance/loan-covenants/
– Cornell Law School Legal Information Institute — Covenants Running with the Land: https://www.law.cornell.edu/wex/run_with_the_land
Educational disclaimer
This explainer is for educational purposes only and does not constitute individualized investment, legal, or tax advice. For decisions about specific contracts or financial arrangements, consult
a qualified attorney, accountant, or licensed financial adviser who can review the specific contract language and your situation.
Practical checklist — how to review covenants
– Locate the covenant section. Note whether clauses are in the loan agreement, indenture, or separate security/documentation.
– Classify each covenant: maintenance covenant (requires the borrower to maintain a financial metric at all reporting tests) versus incurrence covenant (permits actions only if pro forma tests are met). Define terms in agreement (e.g., “EBITDA,” “net debt”).
– Identify the exact formula and test frequency. Look for the numerator, denominator, included/excluded items, and reporting dates.
– Calculate current headroom. Use the most recent financial statements to compute the metric exactly as defined in the covenant.
– Check cure, grace, and notice provisions. Note time allowed to fix breaches and whether lender consent is needed.
– Review remedies and cross-default language. See what triggers acceleration, increased margins, or liens.
– Examine carve-outs and baskets. These permit limited actions (e.g., permitted additional debt, asset sale waivers).
– Confirm reporting and audit obligations. Identify required covenant certifications, auditors’ reports, and delivery timing.
– Plan responses. Prepared options include repayment, refinancings, waivers/amendments, asset sales, or equity injections.
– Seek counsel for ambiguities. Covenants often hinge on precise definitions and drafting—legal review is critical.
Worked numeric example — leverage (maintenance) covenant
Definitions first
– Net Debt = total debt minus cash and cash equivalents, as defined in the agreement.
– EBITDA = earnings before interest, taxes, depreciation, and amortization, as defined in the agreement.
– Leverage ratio = Net Debt / EBITDA.
Scenario
– Covenant: Net Debt / EBITDA must be 3.0x, the incurrence covenant blocks the issuance unless the borrower cures the test.
Practical cures and options when the test fails
– Reduce pro‑forma Net Debt: use cash on hand, sell assets, or exchange equity for debt.
– Increase pro‑forma EBITDA: rarely quick; sometimes target acquisitions are excluded if they have immediate accretive EBITDA, but that’s transaction dependent.
– Seek a waiver or amendment from lenders (may require fees, higher pricing, or tighter other terms).
– Structure the transaction to be outside the covenant (e.g., secured vs. unsecured, or use permitted debt baskets defined in the agreement).
Sample covenant language (illustrative)
– “The Borrower shall not incur any additional Indebtedness if, after giving effect to such incurrence on a pro‑forma basis, the ratio of Net Debt to LTM EBITDA would be greater than
3.5x.” (Illustrative only; numeric thresholds vary by deal.)
Additional sample provisions and drafting notes (illustrative)
– Definition excerpt — Net Debt: “Net Debt means total interest‑bearing debt outstanding less unrestricted cash and cash equivalents, in each case calculated on a consolidated basis in accordance with GAAP.” Clarify exclusions (e.g., letters of credit, intercompany balances) and whether minority interest or operating leases are included.
– Definition excerpt — LTM EBITDA: “LTM EBITDA means consolidated earnings before interest, taxes, depreciation and amortization for the last twelve months, adjusted for nonrecurring items and pro‑forma synergies or dis-synergies specifically defined in Schedule A.”
– Pro‑forma mechanics: Require that any new incurrence be tested on a “pro‑forma basis, giving effect to the incurrence and, if applicable, the application of proceeds and
and any scheduled repayments, prepayments or capitalized transaction costs.” Also specify whether pro‑forma adjustments are allowed only for completed transactions or for signed but not closed deals.
Common covenant categories — quick glossary
– Affirmative covenant: an action the borrower must take (e.g., deliver financial statements).
– Negative covenant: an action the borrower is prohibited from taking without lender consent (e.g., no additional indebtedness).
– Financial covenant: a measurable financial test (e.g., Net Debt / LTM EBITDA ≤ X).
– Basket: a permitted economic allowance inside a negative covenant (e.g., acquisitions up to $25m annually).
– Cross‑default: default on one obligation triggers default on another.
– Springing covenant: a covenant that applies only after a trigger event (e.g., liquidity falls below a threshold).
– Cure period: time allowed to fix a covenant breach before lender remedies accelerate.
Drafting notes — specificity matters
1. Define every capitalized term. Ambiguity creates litigation risk. For example, “Net Debt” should state the debt instruments included, treatment of bank overdrafts, cash earmarked for specific projects, and whether leases are treated under GAAP 842.
2. Set the testing period and look‑back. Specify whether tests use reported financials for the trailing twelve months (LTM) or last fiscal quarter, and whether pro‑forma adjustments are allowed for acquisitions or financings that closed within the test period.
3. State rounding and computation rules. Decide currency conversion rules, consolidation rules (subsidiaries, joint ventures), and whether intercompany debt is included.
4. Provide examples in schedules. A short worked example in the covenant schedule reduces future disputes.
Compliance testing — practical checklist
– Frequency: typically quarterly; some lenders require monthly reporting for tighter deals.
– Inputs: last approved financial statements, schedule of debt, cash balances, adjustments for nonrecurring items.
– Responsible party: name the borrower officer responsible for preparation and delivery.
– Delivery window: e.g., 60 days after quarter end for financial statements; 30 days for covenant certificates.
– Certification: require a signed officer’s certificate attesting to accuracy.
Worked numeric example — Net Debt / LTM EBITDA covenant
Definition: Net Debt / LTM EBITDA ≤ 4.0x
Assumptions:
– Total interest‑bearing debt outstanding = $1,000m
– Cash and cash equivalents = $100m (unrestricted)
– LTM EBITDA = $250m
Calculation:
1. Net Debt = Total debt − cash = $1,000m − $100m = $900m
2. Net Debt / LTM EBITDA = $900m / $250m = 3.6x
Result: covenant satisfied (3.6x ≤ 4.0x).
Pro‑forma incurrence example (new $200m term loan)
Two scenarios for application of proceeds:
A. Proceeds used to repay existing debt:
– New total debt = $1,000m − $200m + $200m = $1,000m (no change)
– If repayment reduces higher‑cost debt and cash is unchanged, Net Debt remains $900m → ratio unchanged.
B. Proceeds go to cash (no repayment):
– Total debt increases to $1,200m
– If cash increases equally and is unrestricted: Net Debt = $1,200m − $100m = $1,100m → 1,100 / 250 = 4.4x (breach)
Drafting consequence: require pro‑forma testing that “gives effect to the incurrence and the application of proceeds” to prevent gaming.
Common negotiation levers for borrowers
– Higher covenant ratios (e.g., 4.5x instead of 4.0x).
– Covenant holiday: no financial covenants for initial 12–24 months.
– Baskets and carve‑outs: permit certain capital expenditure, investments, or acquisitions up to specified amounts without breach.
– Step‑downs: allow tighter ratios over time or after certain deleveraging events.
– Cure mechanisms: limited waiver rights or permitted equity cures (i.e., allowing equity injections to remedy breaches) — state whether permitted and whether they count as debt.
Lender protections to expect
– Positive and continuous reporting requirements.
– Cross‑default to material indebtedness.
– Acceleration rights for covenant breach, often with short cure periods for financial covenant breaches (e.g., 15–30 days).
– Reservation of rights to require additional covenants if credit
deteriorates or triggers occur.
Other typical lender protections
– Affirmative covenants: maintain insurance, preserve corporate existence, comply with laws, maintain books and records, and deliver budgets and forecasts.
– Negative covenants: restrictions on liens, additional debt, investments, asset sales, dividends and share repurchases, and fundamental changes (mergers, change of control).
– Information covenants: monthly or quarterly financial statements, annual audited statements, compliance certificates, and notice of defaults or material adverse changes.
– Events of default beyond covenant breaches: bankruptcy, insolvency, fraudulent representations, cross-defaults to material indebtedness, and nonpayment.
– Remedies: acceleration of principal, enforcement of liens, appointment of receiver, and injunctions—often subject to intercreditor rankings in syndicated or secured structures.
Common negotiation points (what borrowers typically seek)
– Covenant levels and testing frequency: prefer higher ratios and longer testing intervals (quarterly vs. monthly).
– Covenant holidays and step-downs: temporary waivers or automatic looseners tied to time or deleveraging milestones.
– Baskets and carve-outs: explicit permitted amounts for capex, investments, acquisitions, and distributions.
– Equity cures: allow equity injections to be temporarily counted to fix a covenant breach; lenders may limit frequency and amount.
– Measurement definitions: precise definitions for EBITDA, net debt (cash offsets), permitted add-backs, and treatment of non‑recurring items.
– Cure periods and grace periods: longer cure windows for financial covenant breaches.
– Materiality qualifiers: thresholds that limit events of default to material breaches only.
Worked numeric examples (formulas and steps)
Definitions
– EBITDA = Earnings before interest, taxes, depreciation, and amortization. Use the loan agreement’s definition (add-backs may apply).
– Net debt = Total debt (short‑term + long‑term) − unrestricted cash.
– Leverage ratio = Net debt / LTM EBITDA. (LTM = last twelve months)
– Interest coverage ratio = LTM EBITDA / Cash interest expense.
Example 1 — Leverage ratio calculation
Assumptions:
– LTM EBITDA = $200 million.
– Total debt = $950 million.
– Unrestricted cash = $50 million.
Step 1: Net debt = 950 − 50 = $900 million.
Step 2: Leverage = 900 / 200 = 4.50x.
Interpretation: If the covenant requires Leverage ≤ 4.0x, the borrower is in breach; if covenant is ≤ 5.0x, borrower is compliant.
Example 2 — Effect of an equity cure
Same initial numbers; covenant ≤ 4.0x.
– Permit equity cure amount = $150 million equity injected and treated as cash to reduce net debt.
Step 1: New unrestricted cash = 50 + 150 = $200 million.
Step 2: New net debt = 950 − 200 = $750 million.
Step 3: Leverage = 750 / 200 = 3.75x → now compliant.
Note assumptions: lenders may limit number/timing/size of cures and whether cures count as debt for other purposes.
Example 3 — Interest coverage
Assumptions:
– LTM EBITDA = $120 million.
– Cash interest expense (paid) = $30 million.
Interest coverage = 120 / 30 = 4.0x.
Interpretation: If covenant requires Interest Coverage ≥ 3.0x, borrower is compliant. Watch for non-cash interest treatments or capitalization.
Monitoring checklist (for borrowers)
– Monthly: cash balance, debt schedule, interest paid, covenant computations, and variance vs. forecast.
– Quarterly: prepare covenant compliance certificate and supporting schedules; obtain auditor inputs if needed for add-backs.
– Before key actions (dividend, acquisition, capex): run covenant “what‑if” scenarios.
– Document assumptions and retain source documents used in computation.
Monitoring checklist (for lenders)
– Confirm timely delivery of required financials and certificates.
– Reconcile borrower’s computations with audited numbers and ask for clarification on add-backs.
– Watch trailing indicators (declining cash, rising working capital needs, customer concentrations).
– Trigger credit calls early if trends approach covenant limits.
Common covenant breach remedies and processes
– Notice: lender usually gives prompt notice upon discovering a breach.
– Cure period: financial covenants often have short cure periods (e.g., 15–30 days), while other defaults may be treated differently.
– Waiver: lenders may temporarily waive the breach in exchange for fees, increased interest (e.g., margin ratchet), or amended covenants.
– Acceleration: lenders can accelerate debt and declare it due; intercreditor agreements affect priority.
– Forbearance agreements: renegotiated terms that may include extended maturities, new covenants, amortization, or equity injections.
Red flags to watch when negotiating
– Vague definitions for EBITDA, net debt, or permitted add-backs.
– Uncapped or unlimited equity cure usage.
– Monthly testing without operational need—creates short-term volatility risk.
– Broad negative covenants that require lender consent for routine business decisions.
– Cross-default thresholds set at low levels (e.g., $1) for affiliate indebtedness.
Practical negotiation tips
– Ask for clear, objective formulas and examples in the agreement.
– Seek step-downs and covenant holidays tied to realistic forecasts.
– Limit frequency of permitted add-backs and require supporting schedules.
– Ask for reasonable cure periods and caps on remedies for technical breaches.
– Use a covenant “sunset” or review clause for mid‑term renegotiation if business changes.
Quick checklist before signing
– Verify definitions for all key terms (EBITDA, net debt, LTM, cash).
– Run stress-test scenarios (sales down 10–30%, interest rate increases).
– Confirm reporting cadence and internal processes to meet it.
– Negotiate baskets and carve-outs for normal business needs.
– Clarify cure mechanics and whether equity cures count as debt.
Educational disclaimer
This is general educational content about loan covenants. It is not individualized investment, legal, or accounting advice. Consult your attorney, accountant, or financial advisor for guidance tailored to your situation.
Sources
– Investopedia — Covenant: https://www.investopedia.com/terms/c/covenant.asp
– U.S. Securities and Exchange Commission (SEC) — EDGAR and disclosure guidance: https://www.sec.gov
– Loan Syndications and Trading Association (LSTA) — Model Forms & Market Practices: https://www.lsta.org
– Moody’s Investors Service — Corporate Finance and Covenants overview: https://www.moodys.com