Covenants: the lender's tripwires
Maintenance covenants trip while there is still value to protect. Find which one trips first, whether a fall breaches it, and what a cure or a waiver costs.
- Find the EBITDA at which each covenant trips, and which binds first
- Test whether a fall in EBITDA breaches the covenants
- Size the equity cure for a leverage breach
- Compare a cure with a waiver
The intuition
A lease says the tenant must keep at least three months' rent in the bank. The tenant has not missed a payment, but their savings have dropped below that line. The breach lets the landlord talk to the tenant now, while there is still money, rather than after the rent stops.
A maintenance covenant does this for lenders. Two are common: leverage (net debt ÷ EBITDA) must stay at or below a maximum, and interest coverage (EBITDA ÷ interest) must stay at or above a minimum. Both test how far EBITDA can fall, and whichever needs the higher EBITDA trips first. When one trips, the sponsor can cure it with new equity, or pay the lenders to waive it.
EBITDA at the leverage wire = net debt ÷ maximum leverage. EBITDA at the coverage wire = minimum coverage × interest. The higher wire binds. Fall to breach = 1 − higher wire ÷ EBITDA. Cure = net debt − maximum leverage × new EBITDA. Waiver = (fee + step-up) × debt.
Why it works
- The conventions here: the lender's view. Interest = debt × rate, and only EBITDA moves. A cure is equity that repays debt; a waiver costs a fee plus one year of a higher coupon, both on the debt.
- Both covenants are EBITDA tests. Solve each one for EBITDA and compare the two wires with today's EBITDA.
- Which wire binds depends on interest rates. Higher rates raise the interest bill and push the coverage wire up.
- A breach is a covenant default, not a missed payment. Lenders could demand repayment, but in practice they negotiate: they are at the table while there is still value.
- A cure is capital, not a cost: it stays in the company, though it is at risk in a business that has just missed its numbers. A waiver is a cost that buys time.
- Covenant-lite loans have no maintenance tests, only tests that bite when the borrower does something, such as borrowing more. The lenders lose their early warning.
| Interest: 450 × 8% | $36M |
| Leverage wire: 450 ÷ 6.0 | $75M of EBITDA |
| Coverage wire: 2.0 × 36 | $72M of EBITDA |
| Binding: the higher wire | Leverage; EBITDA can fall 25% |
| After a 30% fall: 450 ÷ 70, and 70 ÷ 36 | 6.43x and 1.94x: both breached |
| Equity cure: 450 − 6.0 × 70 | $30M |
A waiver for a 1% fee plus a 1% coupon step-up for a year costs 2% × 450 = $9M: cheaper, but it buys time rather than paying down debt.
The formulas
Debt must not outgrow earnings.
Earnings must cover the interest.
Solve each test for EBITDA.
The first wire to trip.
Repay debt until leverage is back at the maximum.
Paid to the lenders for a year's grace.
Worked example
Interest first. Then solve each covenant for EBITDA; the higher of the two trips first.
See it move
Same company and the same debt. Change how far EBITDA falls, the minimum interest coverage, and the waiver's fee and coupon step-up.
- Deepen the fall in EBITDA. Leverage rises, coverage falls and the cure can only grow; the wires do not move.
- Raise the minimum coverage. The coverage wire rises, and once it passes the leverage wire, coverage becomes the test that binds.
- Raise the waiver fee. The waiver costs more; the cure does not change.
Run it backwards
Same company, reversed: EBITDA has fallen and leverage is over the maximum. How much equity must the sponsor put in to bring it back to the limit?
At the new EBITDA, the most debt the covenant allows is maximum leverage × EBITDA. The cure is the debt above that, repaid with the new equity.
Loan agreements cap how many cures a sponsor may make. One or two is support; a cure every quarter is a business that should be restructured.
Traps
Say it in the interview
“Why do lenders use maintenance covenants, and what happens when one is breached?”
Check yourself
4 fresh questions, with new numbers. Answer each one correctly to finish the chapter. Get one wrong and you will see the full working, then you can try it again with new numbers.
Answers within 1% are marked right. Type the number; $, %, x and M are fine. First tries count toward Learned: the topic is Learned once every chapter is done and 75% of first tries were right.
- Leverage wire = net debt ÷ maximum leverage.
- Coverage wire = minimum coverage × interest.
- The higher wire trips first.
- Cure = net debt − maximum × new EBITDA; waiver = (fee + step-up) × debt.