Glossary
Covenants
Financial covenants and contractual undertakings
Covenants are the undertakings, including financial ratios tested on fixed dates, that the borrower gives in its loan agreement, with an event of default as the sanction for breach.
Definition
Covenants are the undertakings the company gives in its loan agreement for the whole life of the financing. Financial covenants set thresholds for ratios calculated on the consolidated accounts: leverage, the ratio of net debt to EBITDA, and interest cover, the ratio of EBITDA to the interest charge, measured at each test date over the last twelve months. Positive and negative undertakings govern how the business is run: delivery of the accounts and of a compliance certificate, and limits on dividends, new debt, asset disposals and security granted to other creditors. A maintenance covenant is tested on fixed dates, for example each quarter. An incurrence covenant is tested only when the company carries out a given transaction, for example new borrowing. A breach of a financial covenant is an event of default that allows the lenders to accelerate the loan. The company then negotiates a waiver or a reset of the thresholds, in return for a fee or a margin increase. In its guidance of May 2017, the European Central Bank asks banks to flag structures with weak covenants, meaning no financial covenant or a large headroom, and considers that leverage above 6x total debt to EBITDA raises concerns for most sectors. Among US debt funds, a guide published by BlackRock in June 2026 states that 15% of recent private credit loans were covenant-lite, compared with 89% of loans in the traded loan market, on data from late 2022 and early 2023.
Worked example
A mid-cap services company carries €160m of net debt with a leverage covenant set at 5.0x the EBITDA of the last twelve months. Its business plan forecasts €40m of EBITDA, a leverage of 4.0x. The headroom is 20%: EBITDA can fall to €32m before the ratio is breached (160 ÷ 32 = 5.0).
Points to check
- The contractual definition of EBITDA and the permitted adjustments (synergies, non-recurring items)
- The headroom between the business plan and the threshold of each ratio
- The frequency of the tests and the type of each covenant, maintenance or incurrence
- The right to cure a breach with an equity injection (equity cure)
- The restrictions on dividends, new debt and asset disposals
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