3.4 Covenants and security in plain English

A loan is a promise to repay. But a lender that waits until maturity to find out whether the promise will be kept has no way to protect itself along the way. So loan agreements add two kinds of protection: covenants, which are promises about how the borrower will behave, and security, which gives the lender a claim on assets if things go wrong.

Covenants and security explain why private lenders often recover more than other creditors, and why a borrower's problems usually show up first as a conversation with its lenders rather than a default. This lesson introduces both. PC301 covers the details.

Affirmative and negative covenants

A covenant is a promise in the loan agreement. There are two basic kinds.

Affirmative covenants are things the borrower must do. For example:

• deliver financial statements, often monthly or quarterly, plus audited annual accounts
• keep its assets insured
• pay its taxes and comply with the law
• tell the lender about any default or major lawsuit

Negative covenants are things the borrower must not do, or may do only within agreed limits. For example:

• take on more debt
• grant liens on its assets to other lenders
• pay dividends or make other payments to its owners
• sell major assets, or merge with another company
• make large investments or acquisitions

Negative covenants protect the lender's place in the capital structure. Without them, the borrower could borrow more ahead of or alongside the lender, or send cash out to the sponsor. The agreed exceptions are often called baskets: for example, the borrower may take on up to a set amount of extra debt without asking.

Financial covenants: maintenance vs. incurrence

Financial covenants use numbers from the borrower's accounts. The most common is a maximum total leverage ratio:

Total leverage = total debt ÷ EBITDA

EBITDA (earnings before interest, taxes, depreciation and amortization) is a rough measure of the cash profit a business generates. A leverage ratio of 5.0x means debt is five times annual EBITDA. Other common tests include a minimum interest coverage ratio (EBITDA ÷ interest expense), which checks the borrower can afford its interest.

How often a covenant is tested matters as much as its level:

The borrower confirms it passes its maintenance covenants each period in a compliance certificate sent to lenders.

A loan without maintenance covenants is called covenant-lite (or "cov-lite"). Cov-lite loans are common in the broadly syndicated loan market, where loans are spread across many investors. Middle-market private loans more often keep at least one maintenance covenant. That early warning is one of the benefits private lenders cite for their approach, though some larger private loans have also moved toward cov-lite terms.

Headroom: how much room before a breach

Covenants are not set at today's numbers. They are set with a cushion, called headroom, so that normal ups and downs don't cause a breach. Illustratively, lenders often set leverage covenants so EBITDA could fall by something like 25–35% before a breach.

Take Northfield Components, a fictional borrower with $200 million of debt and $40 million of EBITDA. Its leverage is 5.00x. The covenant maximum is 7.00x.

The breach point is $200 million ÷ 7.00 ≈ $28.6 million of EBITDA, a fall of about 29%. A covenant with too little headroom causes breaches over minor blips. One with too much gives the lender no early warning at all.

One caution: covenants use EBITDA as defined in the loan agreement, which often allows add-backs (adjustments for one-off costs or expected savings). A generous definition makes a covenant easier to pass. PC301 looks at this closely.

Security: what protects the lender

Covenants give warning. Security decides what the lender can recover. A typical senior secured private loan has a security package made up of:

• First-priority liens on substantially all assets: receivables, inventory, equipment, intellectual property, bank accounts and, often, real estate.
• Share pledges: the shares of the borrower and its subsidiaries are pledged to the lender. If the lender enforces, it can take control of, or sell, the whole business rather than selling assets piece by piece.
• Guarantees: the borrower's subsidiaries, and usually its parent holding company, promise to repay the loan if the borrower can't. This matters because assets and cash are often held in subsidiaries, not the borrower itself.

Lenders must also perfect their liens, for example by filing public notices, so their claim holds up against other creditors.

What happens when a covenant is breached

Breaking a covenant is usually an event of default. On paper, this gives the lender strong rights: it can accelerate the loan (demand immediate repayment), stop further lending under a revolver, charge a higher default rate of interest, and eventually enforce its security.

In practice, lenders rarely accelerate straight away. Forcing a default can destroy the value of the business they are relying on to be repaid. Instead, the breach starts a negotiation, and usually ends in one of these:

• a waiver: the lender agrees to excuse the breach, often for a fee
• an amendment: the terms are changed, for example a looser covenant in return for a higher spread, some PIK interest, tighter restrictions or a partial repayment
• fresh equity from the sponsor: many agreements let the owner inject cash to fix the ratio, known as an equity cure

The key point is that the covenant puts the lender at the table early, while there is still value to protect.

Key terms

• Covenant: a promise by the borrower in the loan agreement.
• Affirmative covenant: something the borrower must do.
• Negative covenant: something the borrower must not do, or may do only within limits.
• Basket: an agreed exception within a negative covenant.
• EBITDA: earnings before interest, taxes, depreciation and amortization; a proxy for cash profit.
• Total leverage ratio: total debt ÷ EBITDA.
• Maintenance covenant: a financial test checked regularly, often quarterly.
• Incurrence covenant: a test checked only when the borrower takes a specific action.
• Covenant-lite: a loan with no maintenance covenants.
• Headroom: the cushion between current results and the covenant level.
• Share pledge: a lender's security over the shares of the borrower or its subsidiaries.
• Guarantee: a promise by another group company to repay if the borrower can't.
• Event of default: a breach that gives the lender the right to act, including demanding repayment.
• Waiver: the lender's agreement to excuse a breach.
• Equity cure: the sponsor injecting equity to fix a covenant breach.

Key takeaways

• Affirmative covenants say what the borrower must do; negative covenants limit what it can do.
• Maintenance covenants are tested regularly and give early warning; incurrence covenants apply only when the borrower acts.
• Middle-market private loans more often keep maintenance covenants than broadly syndicated loans, which are frequently cov-lite.
• Security usually means liens on substantially all assets, share pledges and guarantees from group companies.
• A breach usually leads to a negotiated waiver or amendment, often with a fee or higher pricing, not immediate acceleration.