Two types: affirmative and negative
Affirmative covenants require the borrower to do something: maintain insurance, provide financial statements quarterly, pay taxes on time, maintain key personnel. Negative (restrictive) covenants prohibit certain actions: taking on additional debt beyond a specified level, making acquisitions above a threshold, paying dividends without lender approval, selling material assets, or granting liens on assets to other creditors. Negative covenants are the primary protective tool — they prevent the borrower from taking actions that would impair the lender's security.
| Covenant Type | Example | What it protects |
|---|---|---|
| Financial maintenance | Net leverage ≤ 4.5x EBITDA | Prevents excessive leverage build-up |
| Debt incurrence | No additional debt if leverage > 3.5x | Maintains seniority of existing debt |
| Restricted payments | No dividends if leverage > 4.0x | Prevents cash leakage to equity |
| Asset sale | Proceeds must repay debt or reinvest | Protects collateral pool |
| Change of control | Acquisition triggers put at 101 | Protects against credit deterioration |
Maintenance vs. incurrence covenants
This is the critical distinction in leveraged lending. Maintenance covenants must be tested every quarter regardless of what the borrower does — if a leverage ratio exceeds the limit, the loan is in default even if no payment has been missed. They provide early warning and give lenders leverage to restructure before full distress. Incurrence covenants are only tested when the borrower wants to take a specific action (e.g., issue more debt, pay a dividend) — they don't provide ongoing protection. The shift from maintenance to incurrence covenants in "cov-lite" loans was one of the most significant changes in leveraged lending in the 2010s.
Covenant breach and its consequences
A covenant breach gives lenders the right to accelerate the loan — demand immediate full repayment. In practice, this right is rarely exercised directly; it is instead used as leverage to renegotiate terms, extract fees ("amendment and waiver fees"), or take security that previously existed only in unsecured form. For distressed investors, covenant breaches are often the trigger that surfaces a company's financial stress and creates restructuring opportunities. The quality of covenants in a loan package directly determines how much control lenders retain if things go wrong.
"Covenants are the difference between a loan agreement and a blank cheque. Their erosion in cov-lite loans has been the longest-running negotiation defeat for creditors in modern lending history." — A credit market observation
What this means for you
For credit investors and leveraged buyout analysts, reading and understanding the covenant package is as important as modelling the cash flows. A tight covenant package materially reduces credit risk; a cov-lite structure requires higher compensation. The credit analysis question is not just "can this company service its debt?" but "what happens if it can't — and do we have the contractual tools to intervene before value is destroyed?"