Debt Covenants Explained: Maintenance vs Incurrence

What Are Debt Covenants?

Debt covenants are contractual provisions in credit agreements that restrict borrower activities and require maintenance of certain financial metrics. Lenders include covenants to protect their investment by limiting actions that could impair the borrower's ability to repay and by providing early warning signals when credit quality deteriorates.

Understanding covenants is essential for investment banking because they directly affect deal structuring, credit analysis, and transaction execution. In leveraged finance, the covenant package significantly influences pricing, proceeds, and borrower flexibility. For LBO transactions, covenants constrain how portfolio companies can operate and when sponsors can extract value. For distressed situations, covenant violations often trigger restructuring discussions.

Covenants fall into two fundamental categories: maintenance covenants and incurrence covenants. The distinction between these categories represents one of the most important concepts in leveraged finance, affecting credit risk, borrower flexibility, and lender protection in fundamentally different ways. Interviewers frequently test this distinction because it reveals whether candidates genuinely understand credit mechanics or have only surface-level knowledge.

This guide provides comprehensive coverage of both covenant types, common financial tests, market trends toward covenant-lite structures, and practical applications for interviews and deal work.

The Fundamental Distinction: Maintenance vs. Incurrence

The difference between maintenance and incurrence covenants centers on when and how financial tests are applied.

Maintenance Covenants

Maintenance covenants require borrowers to continuously satisfy financial tests at regular intervals, typically every quarter. The borrower must meet specified thresholds regardless of any specific action or transaction. If the borrower fails to satisfy the test at any measurement date, a covenant violation occurs even if the borrower has taken no affirmative action that caused the deterioration.

Key characteristics of maintenance covenants:

Maintenance covenants function as trip wires that alert lenders to credit deterioration and give them intervention rights. Even if a borrower's business is fundamentally sound, temporary underperformance can trigger violations that shift negotiating power to lenders.

Incurrence Covenants

Incurrence covenants only apply when the borrower takes a specific action, such as incurring additional debt, making acquisitions, paying dividends, or executing other defined transactions. The borrower must satisfy financial tests at the time of the specific action, but there is no ongoing obligation to maintain those levels.

Key characteristics of incurrence covenants:

Incurrence covenants function as gates that prevent borrowers from taking specific harmful actions while allowing operational flexibility. A borrower can experience significant performance deterioration without technical default, as long as it does not attempt restricted transactions.

The Critical Difference in Practice

Consider a company with 4.0x leverage and a 4.5x leverage covenant:

Under maintenance covenants: If EBITDA declines such that leverage rises to 4.6x at quarter-end, the borrower violates the covenant even though it took no specific action. The lender now has rights to demand amendment fees, additional collateral, or potentially acceleration.

Under incurrence covenants: The same EBITDA decline causes no violation because no triggering action occurred. The borrower only faces restriction if it attempts to incur additional debt, pay dividends, or take other restricted actions that require satisfying the leverage test.

This difference has profound implications for borrower-lender dynamics during distress. Maintenance covenants give lenders earlier intervention rights; incurrence covenants preserve borrower flexibility until specific actions are attempted.

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Maintenance Covenants in Detail

Common Maintenance Covenant Tests

Maintenance covenants typically focus on leverage and coverage metrics that measure debt capacity and debt service ability.

Leverage Ratio (Debt/EBITDA)

The most fundamental maintenance covenant limits total leverage:

A typical covenant might require leverage not to exceed 5.0x at any quarter-end. If EBITDA declines or debt increases such that the ratio exceeds the threshold, a violation occurs.

Leverage covenants often feature step-downs over time, requiring progressively lower leverage as the borrower is expected to deleverage. A covenant might start at 5.5x and step down to 4.5x over three years.

First Lien Leverage Ratio

For capital structures with multiple debt tranches, first lien leverage measures leverage attributable only to senior secured debt:

This protects senior lenders specifically, as subordinated debt does not count against the test.

Interest Coverage Ratio

Coverage ratios measure ability to service debt:

A minimum coverage requirement of 2.0x means EBITDA must be at least twice interest expense. Declining EBITDA or increasing interest costs can trigger violations.

Fixed Charge Coverage Ratio

A broader measure including additional fixed costs:

This more conservative test captures capital expenditure requirements and principal amortization.

EBITDA Definition Considerations

The definition of "EBITDA" in credit agreements significantly affects covenant calculations and is heavily negotiated. Credit agreement EBITDA typically includes adjustments beyond standard financial statement EBITDA:

Common EBITDA add-backs:

These add-backs can create significant cushion between reported EBITDA and covenant EBITDA. A company might report $100 million GAAP EBITDA but have $130 million covenant EBITDA after permitted adjustments.

The permitted add-backs and their caps represent key negotiating points. Borrowers want maximum flexibility; lenders want EBITDA that reflects actual cash generation ability.

Covenant Cushion and Headroom

Borrowers negotiate for adequate cushion between projected performance and covenant thresholds. If a company expects 4.0x leverage, negotiating a 5.0x covenant provides 25% EBITDA cushion before violation.

Insufficient cushion creates constant violation risk and restricts operational flexibility. Excessive cushion reduces lender protection and monitoring effectiveness.

Consequences of Maintenance Covenant Violations

When maintenance covenants are violated, several consequences may follow:

Technical default: The violation constitutes an event of default under the credit agreement, though not necessarily an immediate payment default.

Amendment negotiations: In practice, lenders typically negotiate amendments rather than immediately accelerating. Borrowers pay amendment fees, agree to tighter covenants, provide additional security, or accept other modifications.

Equity cure rights: Many credit agreements permit sponsors to inject equity to cure covenant violations. The equity contribution is added to EBITDA or reduces debt for covenant calculation purposes, restoring compliance.

Understanding LBO mechanics helps contextualize how covenant violations affect sponsor economics and portfolio company management.

Incurrence Covenants in Detail

Common Incurrence Covenant Tests

Incurrence covenants restrict specific actions unless financial tests are satisfied at the time of the action.

Debt Incurrence

Limits on incurring additional debt, typically tested on a pro forma basis:

"The Borrower shall not incur additional Indebtedness unless, after giving pro forma effect to such incurrence, the Total Leverage Ratio does not exceed 4.0x."

The company can have leverage above 4.0x due to performance deterioration, but it cannot take on new debt that would increase leverage further.

Restricted Payments

Limits on dividends, distributions, and other payments to equity holders:

"The Borrower shall not make Restricted Payments unless, after giving pro forma effect, the Total Leverage Ratio does not exceed 3.5x."

This prevents equity value extraction when the company is highly leveraged, protecting lender recovery prospects.

Investments and Acquisitions

Limits on making investments or acquisitions:

"The Borrower shall not make Investments exceeding $25 million in the aggregate unless, after giving pro forma effect, the Interest Coverage Ratio exceeds 2.0x."

Prevents over-expansion or speculative investments when credit metrics are strained.

Asset Sales

Limits on disposing of assets, often with requirements for proceeds application:

"The Borrower shall not consummate Asset Sales unless net proceeds are applied to prepay Term Loans within 365 days."

Ensures valuable collateral is not stripped without lender benefit.

Ratio Debt and Basket Structures

Incurrence covenants typically include permitted baskets allowing certain activities without satisfying financial tests:

Fixed baskets: Specific dollar amounts permitted regardless of financial tests. "The Borrower may incur up to $50 million of additional debt without satisfying the leverage test."

Ratio-based capacity: Additional capacity unlocked when financial tests are satisfied. If leverage is below 3.5x, unlimited additional debt incurrence might be permitted.

Builder baskets: Accumulated capacity based on retained earnings or other metrics. The basket grows over time as the company generates profits, providing increasing flexibility.

These structures create layered flexibility where borrowers have baseline rights through fixed baskets and additional rights when performing well.

Grower and Starter Baskets

Modern credit agreements often include baskets that scale with company size:

Grower baskets: Calculated as the greater of a fixed dollar amount and a percentage of EBITDA or total assets. As the company grows, the basket expands proportionally.

"General Investment basket: the greater of $30 million and 15% of LTM EBITDA"

Starter baskets: Fixed amounts available immediately upon closing, providing baseline flexibility.

These provisions recognize that appropriate basket sizes depend on company scale, preventing overly restrictive limitations as businesses grow.

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Covenant-Lite Loans: The Market Evolution

What Is Covenant-Lite?

Covenant-lite (cov-lite) loans are leveraged loans that lack maintenance covenants entirely, relying only on incurrence covenants for financial discipline. These structures provide maximum borrower flexibility by eliminating the periodic testing that triggers lender intervention during performance deterioration.

Cov-lite loans first appeared in the mid-2000s, retreated after the financial crisis, and have since become dominant in the broadly syndicated loan (BSL) market. Currently, over 85% of institutional leveraged loans are structured as cov-lite.

Why Cov-Lite Became Prevalent

Several factors drove cov-lite adoption:

Borrower preference: Private equity sponsors prefer maximum operational flexibility without lender intervention during temporary underperformance.

Competitive dynamics: As leveraged loan markets became more competitive, borrowers demanded and received increasingly favorable terms.

CLO demand: Collateralized loan obligations became major buyers of leveraged loans, and their structural features made them less focused on maintenance covenant protection.

Low default environment: Extended periods of low defaults reduced lender concern about covenant protection.

Recovery expectations: Strong secured recoveries in recent cycles reduced urgency around early intervention.

The Private Credit Distinction

While cov-lite dominates the syndicated market, private credit (direct lending) transactions typically retain maintenance covenants. Private credit lenders argue that maintenance covenants provide:

However, competitive pressure from the BSL market has caused some erosion of maintenance covenants in larger private credit transactions, particularly those competing directly with syndicated alternatives.

Implications of Cov-Lite Structures

The prevalence of cov-lite has significant implications for credit dynamics:

Delayed recognition of problems: Without maintenance covenants, deteriorating credits may not face formal covenant violations until attempting restricted actions, by which time problems may have compounded.

Reduced lender leverage: Lenders have fewer opportunities to demand amendments, fees, or improved terms during the loan's life.

Different default patterns: Defaults occur later in the deterioration cycle, often with more severe outcomes when they finally occur.

Amendment dynamics: Fewer amendments occur (no violations to cure), but when problems emerge, they may require more comprehensive restructuring.

Lower recovery expectations: Some research suggests cov-lite loans may have lower recovery rates due to later intervention and more severe distress at default.

Understanding these dynamics is important for credit analysis, restructuring, and evaluating leveraged finance transactions.

Affirmative and Negative Covenants

Beyond financial covenants, credit agreements include operational covenants governing borrower conduct.

Affirmative Covenants

Affirmative covenants require borrowers to take specific actions:

These covenants ensure lenders receive information and the borrower maintains proper corporate hygiene.

Negative Covenants

Negative covenants prohibit or restrict specific actions:

Each negative covenant includes exceptions and baskets permitting specified activities. The detailed negotiation of these exceptions significantly affects borrower flexibility.

Covenant Violations and Remedies

Types of Defaults

Credit agreements distinguish between different default types:

Non-payment defaults: Covenant violations that are events of default but do not involve payment failure. These often include cure periods before becoming formal defaults.

Cure Periods

Many covenants include grace periods during which borrowers can remedy violations:

The availability and length of cure periods affect how aggressively lenders can respond to technical violations.

Equity Cure Rights

Many sponsor-backed credit agreements permit equity contributions to cure covenant violations:

"Upon delivery of an Equity Cure Notice, the Borrower may receive an equity contribution from the Sponsor that shall be added to EBITDA for purposes of calculating financial covenants."

Typical limitations on equity cures include:

Equity cures provide sponsors a safety valve to avoid technical defaults while preserving lender protections over time.

Amendment and Waiver Processes

When violations occur, borrowers typically seek amendments or waivers:

Waivers: Lenders agree to overlook a specific past violation without changing agreement terms. Often used for minor or technical violations.

Amendments: Lenders agree to modify covenant levels or definitions prospectively. Requires formal amendment documentation and typically involves fees.

Amendment negotiations require lender consent, with voting thresholds depending on the provision being modified:

Understanding consent requirements helps predict amendment feasibility during distressed situations.

Covenants in LBO Transactions

Typical LBO Covenant Structures

LBO credit agreements typically include:

Senior secured term loans: Often cov-lite in syndicated transactions, with only incurrence covenants. If maintenance covenants exist, they typically include leverage ratio and sometimes coverage ratio.

Revolving credit facilities: More likely to include maintenance covenants because banks (rather than institutional investors) provide revolvers and prefer ongoing monitoring. The maintenance covenant may apply only when revolver utilization exceeds a threshold (e.g., tested only when >35% drawn).

High-yield bonds: Always incurrence-only, with no maintenance covenants. Bondholders accept this limitation in exchange for higher yields and transferability.

Springing Covenants

Some structures include springing maintenance covenants that only become active under specified circumstances:

"The Total Leverage Ratio covenant shall be tested only if Revolving Loans outstanding exceed 35% of Revolving Commitments at quarter-end."

This preserves cov-lite flexibility while providing maintenance covenant protection when the revolver is significantly utilized (indicating the borrower may be under stress).

Covenant Considerations in LBO Modeling

When building LBO models, covenants affect several elements:

Debt capacity: Maximum leverage depends partly on covenant thresholds lenders will accept

Dividend recaps: Restricted payment covenants limit when and how sponsors can extract value

Add-on acquisitions: Investment and debt incurrence covenants constrain acquisition activity

Operational flexibility: Overly restrictive covenants may impair management's ability to execute value creation plans

For more on LBO mechanics, see our guide on what makes a good LBO candidate.

Interview Questions on Covenants

"What's the difference between maintenance and incurrence covenants?"

"Maintenance covenants require borrowers to continuously satisfy financial tests at regular intervals, typically quarterly, regardless of any specific action. If metrics deteriorate below thresholds, the borrower is in violation even without taking any triggering action. Incurrence covenants only apply when the borrower takes specific actions like incurring debt, paying dividends, or making acquisitions. The borrower must satisfy the test at the time of that action, but deteriorating performance alone doesn't create a violation. The practical difference is that maintenance covenants give lenders earlier intervention rights during deterioration, while incurrence covenants preserve borrower flexibility until specific actions are attempted."

"Why have covenant-lite loans become so prevalent?"

"Cov-lite loans dominate the syndicated market due to several factors. First, competitive dynamics as borrowers gained leverage in a low-default environment. Second, CLO demand since these institutional buyers became the primary syndicated loan purchasers and their structures don't require maintenance covenant protection. Third, sponsor preference for maximum operational flexibility without lender intervention during temporary underperformance. Fourth, strong historical recoveries on senior secured loans reduced lender urgency around early intervention. The result is over 85% of institutional leveraged loans are now cov-lite."

"What happens when a company violates a maintenance covenant?"

"A maintenance covenant violation constitutes a technical event of default, triggering several lender rights. Lenders can accelerate the loan, demanding immediate repayment. They can refuse to fund additional borrowings under revolving facilities. They can charge default interest rates. In practice, lenders typically negotiate amendments rather than immediately accelerating. The borrower pays amendment fees, agrees to tighter covenants, provides additional security, or accepts other modifications. Many sponsor-backed deals include equity cure rights allowing the sponsor to inject equity that's added to EBITDA for covenant calculations, restoring compliance."

"What are typical covenant levels in an LBO?"

"Covenant levels depend on the specific credit and market conditions, but typical maintenance covenants might include total leverage starting at 5.5-6.0x stepping down to 4.5-5.0x over time, and interest coverage of 2.0-2.5x. Incurrence test levels are typically set tighter since they're only tested upon taking action: debt incurrence might require pro forma leverage below 4.5x, restricted payments might require leverage below 3.5-4.0x, and there are typically fixed baskets providing baseline flexibility. EBITDA add-backs can create substantial cushion between reported and covenant EBITDA."

Key Takeaways

Conclusion

Debt covenants represent a fundamental aspect of credit analysis and leveraged finance that every investment banking professional must understand. The distinction between maintenance and incurrence covenants goes to the heart of borrower-lender dynamics, determining when lenders gain intervention rights and how much flexibility borrowers retain during periods of underperformance.

The evolution toward covenant-lite structures in the syndicated market has profoundly changed credit dynamics, delaying lender intervention but preserving borrower flexibility. Understanding this evolution helps explain current market practices and informs analysis of credit risk in leveraged transactions.

For interviews, demonstrating sophisticated understanding of covenant mechanics signals genuine knowledge of credit markets beyond surface-level familiarity. Be prepared to explain the maintenance versus incurrence distinction clearly, discuss implications of covenant-lite structures, and walk through what happens when violations occur. This knowledge applies directly to LBO analysis, restructuring situations, and any role involving leveraged finance transactions.

Master these concepts, and you will be well-prepared for technical discussions of credit structures that are central to leveraged finance, private equity, and restructuring practices in investment banking.