Covenant reset

A covenant reset is the redefinition of the financial covenant levels of a loan, in particular the maximum leverage ratio, to align them with the company’s performance or scope. It occurs in two situations. In a renegotiation, a borrower at risk of breach obtains new thresholds from its lenders in exchange for a fee, a margin increase or an equity injection. Private debt lenders themselves ask for this revision when an amend and extend comes with new debt. In the initial documentation, an auto reset clause raises the thresholds after a defined event. Lenders limit it to a permitted acquisition financed by the loan, or even to an acquisition that increases consolidated EBITDA by more than 20%. Covenant levels are calculated from a reference financial model (base case) and a headroom on forecast EBITDA. This headroom used to be 25%; in 2023, most European transactions used 30% and above, documentation known as cov-loose 35% and above, and large transactions 40% and above. Maximum leverage is tested every quarter. For the borrower, the reset is negotiated on the reference EBITDA, the inclusion of the last twelve months’ EBITDA of an acquired target, the synergies allowed and the duration of the new thresholds.

A mid-sized company financed with a €120m unitranche has a leverage covenant set at 5.5x. Its EBITDA falls from €30m to €23m and leverage reaches 5.2x. It obtains a reset of the threshold to 6.5x for four quarters in exchange for a 0.5% fee and a margin increase of 0.5 percentage point.

• The headroom on the reference model’s EBITDA: 30% or more in 2023.
• The event that triggers an auto reset and the acquisition size threshold.
• The definition of EBITDA and net debt used for the test.
• The consideration requested: fee, margin, equity injection.