Lesson 3 of 7
Covenants, and what they protect
A covenant is a promise inside a loan agreement, and breaching one can force a company to renegotiate its debt long before it misses a payment.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- A covenant is a promise written into a loan agreement, backed by a right the lender can enforce if the promise breaks.
- A maintenance covenant is tested every quarter regardless of what the company does, which is why it can bind before any missed payment.
- A 10 percent fall in trailing twelve-month EBITDA can push a company from inside a covenant limit to over it.
A covenant is a condition a company agrees to keep while a loan is outstanding. Break one, and the lender can demand repayment, charge a fee, or renegotiate the loan on worse terms, well before the company misses an actual payment.
How close one company runs to its covenant
- Now · net debt 320, EBITDA 1003.2x
- If EBITDA falls 10% · net debt 320, EBITDA 903.56x
Covenant limit, net debt to EBITDA: 3.5x
A promise, not a suggestion
A covenant sits inside the credit agreement itself, so breaking one is a breach of contract, not a soft warning. It comes in two broad kinds.
Maintenance covenant
- Tested at every measurement date, whether or not the company borrows anything new.
- More common in bank loans.
Incurrence covenant
- Tested only when the company takes a specific action, such as issuing more debt or paying a dividend.
- More common in bonds sold to public investors, so tested less often.
Many institutional term loans are covenant-lite, with no maintenance test at all; a revolver's covenant can spring into effect only once it is drawn.
A common form: leverage and coverage limits
A covenant most often limits two figures. A leverage ratio caps net debt to EBITDA under a stated multiple; a coverage ratio floors EBITDA above a stated multiple of interest expense. A leverage covenant is usually tested against trailing twelve-month EBITDA, not a single quarter's. Both figures are read from numbers a company already reports each quarter, which is why they can be approximated from outside; the agreement's own definitions decide the exact result.
Read them in the filing
A public company's credit agreements are filed as exhibits under Item 15 of its Form 10-K, and the agreement itself states each covenant's definition and limit in full, including which add-backs to EBITDA it allows.
Find it in a real 10-K
- Debt note in Item 8: the facilities and the covenant.
- MD&A liquidity: the compliance statement, sometimes the ratio itself.
- Item 15 exhibit index: the credit agreement.
- In the agreement, search "Consolidated EBITDA" and "Financial Covenants".
A new or amended credit agreement, including one that resets a covenant after a company runs close to it, is usually reported straight away, on a Form 8-K under Item 1.01, a material definitive agreement. An acceleration of the debt is reported under Item 2.04.
What a breach actually forces
Breaching a covenant is called a technical default: the company has broken a term of the loan even though it is current on every payment. The lender can then accelerate the debt, demanding it back in full. In practice it more often grants a waiver, in exchange for a fee, a higher interest rate, or a tighter covenant going forward. A covenant breach on one loan can also trigger a cross-default clause in a company's other debt, which is how one weak quarter turns into a company-wide renegotiation.
Check yourself
What is the difference between a maintenance covenant and an incurrence covenant?
- A maintenance covenant only applies to bonds
- A maintenance covenant is tested every period regardless of what the company does; an incurrence covenant is tested only when the company takes a specific action
- An incurrence covenant is stricter
Show the answer
Answer: B.
Maintenance covenants, common in bank loans, run at every measurement date. Incurrence covenants, common in bonds, are tested only against a specific action such as issuing new debt.Net debt is 320. A covenant caps net debt to EBITDA at 3.5x. At what EBITDA is the covenant exactly at its limit?
- 80
- 100
- about 91.4
Show the answer
Answer: C.
320 ÷ 3.5 is about 91.4. EBITDA above that keeps the ratio under 3.5x; below it, the ratio breaches the covenant.A company breaches a maintenance covenant but is current on every interest and principal payment. What has happened?
- Nothing, since covenants only matter at maturity
- A technical default: a broken loan term despite being current on payments, which can let the lender demand repayment or renegotiate
- An automatic bankruptcy filing
Show the answer
Answer: B.
A technical default breaks a term of the loan, not a payment. It gives the lender a right to act, most often used to force a renegotiation or a fee rather than an immediate demand for repayment.Sources
- Item 15 of Form 10-K: the exhibits, including a company's own credit agreements and their covenant definitions.
- Form 8-K Item 1.01: material definitive agreements, including a new or amended credit agreement.
What this leaves out
- The covenant limit and the EBITDA figures here are round invented inputs, chosen so the arithmetic can be checked by hand.
- A credit agreement's own definition of EBITDA can differ from a company's reported non-GAAP EBITDA, and only the filed agreement settles which one governs.
- Nothing here says any company is close to breaching a covenant, or what any lender would do if it did. Nothing here is advice about any security.