Covenant
A covenant is a promise in a loan agreement about what the borrower will and will not do: keep leverage below a ratio and interest cover above one (financial covenants, tested quarterly), deliver accounts, not borrow more, sell assets or pay dividends without consent. It is the lender's early warning and its lever — a breach lets the lender demand repayment, and in practice renegotiate the price of not doing so.
- Also known as
- Financial covenant, Loan covenant, Maintenance covenant
- Used at
- every bank loan and most private credit; leveraged buy-out debt, where the covenants are the sponsor's constraint; bonds carry looser "incurrence" covenants that bite only when the borrower acts
- Binding
- yes — a breach is an event of default; the lender's remedies are acceleration, enforcement of security, or a waiver on terms
- Typical financial covenants
- net debt to EBITDA (maximum, stepping down over the loan's life), interest cover (minimum EBITDA to interest, often 2–3×), cash-flow cover, and capital expenditure limits; tested quarterly on trailing twelve months
- Typical headroom
- covenants set 20–30% away from the plan, so that a moderate miss is a conversation and a large one a default; "covenant-lite" loans, common in large buy-outs since 2017, carry only incurrence tests
- Parties
- the borrower and its board, the lenders and their agent, and for a fintech the regulator, whose capital rules are a covenant the lenders cannot waive
How a covenant works in practice
A company borrows €90m against €20m of EBITDA: 4.5× leverage. The loan agreement sets a maximum of 5.5× stepping down to 4.0× over four years, and minimum interest cover of 2.5×, each tested every quarter on the last twelve months' numbers, which the borrower must deliver within 45 days of the quarter's end with a compliance certificate. While the numbers hold, the covenants are paperwork. When EBITDA falls, they are the lender's seat at the table: a breach lets the lender accelerate the loan, which it rarely wants, or grant a waiver — for a fee, a higher margin, tighter terms, a capital injection from the shareholders, or, in a buy-out, warrants or a share of the equity.
The negotiation at signing is about definitions and headroom. "EBITDA" for covenant purposes is defined — with caps on the add-backs a borrower may include — because a covenant tested on an uncapped adjusted EBITDA is not a test. Headroom is set so that the plan can miss by a margin before the covenant is hit; a sponsor that sets it too tight spends the loan's life negotiating waivers, one that sets it too loose has paid for flexibility it did not need.
For a licensed fintech the lenders' covenants sit alongside the regulator's: a loan that allows a dividend the regulator forbids is a loan that will not be serviced, and lenders to regulated groups add a covenant that the regulated entity stays compliant.
Example
A payments group's €90m facility carries a 5.0× leverage covenant, tested quarterly. A large merchant leaves and EBITDA falls from €20m to €16.5m: leverage is 5.45×, a breach reported in the Q3 compliance certificate. The lenders do not accelerate. They agree a reset: the covenant moves to 6.0× for four quarters then steps back; the margin rises by 75 basis points (€675,000 a year); the sponsor injects €8m of equity to repay debt and shows good faith; the lenders take a 1% waiver fee (€900,000) and a right to appoint an observer to the board. The equity holders keep the company; the lenders are paid for the risk they did not take on at signing; and the next quarter's certificate, at 4.9×, is filed on time.
Common mistakes
- Covenant EBITDA defined loosely, so the test measures the borrower's optimism. - Headroom set on the plan's best case, so the first ordinary miss is a default. - Treating a breach as a technicality; it is the moment the lender's price changes. - Borrowers hiding a coming breach until the certificate, when a call three months earlier would have cost less. - Lenders to a regulated group without a covenant on the regulated entity's compliance — the regulator's action arrives before the leverage test does.