Covenant

A covenant is a contractual obligation that a borrower must comply with toward its lenders. Such obligations may require, for example, that certain financial ratios are not exceeded. If they are breached, lenders can exercise special rights or declare the loan due.

Three groups are distinguished. Financial covenants attach to ratios, typically net debt to EBITDA, interest cover, debt service cover and a cap on capital expenditure. Testing is usually quarterly against a contractually defined adjusted EBITDA. Information covenants require regular reporting, such as monthly and quarterly figures, annual accounts and a compliance certificate. Undertakings restrict specific actions, such as further borrowing, granting security to third parties, distributions, acquisitions or the sale of material assets. Setting the levels is a question of headroom: a safety margin is customary, allowing the company to fall short of plan without immediately breaching.

For an impending breach many agreements provide a cure right through an equity injection, limited in number and frequency. A breach does not automatically accelerate the loan but first gives lenders bargaining power: waivers against a fee, higher margins, additional security or tighter reporting are the usual outcomes. Covenants are therefore less a sanction than an early warning system giving lenders a seat at the table before difficulties translate into missed payments.

Beyond the levels, the definitions of the underlying figures are decisive in negotiation, because a credit agreement sets its own definitions of EBITDA, net debt and capital expenditure that differ from accounting. In particular the list of permitted adjustments and the crediting of expected effects of future measures matter economically. The testing date also needs settling, because a test at the seasonal low produces different results from one at the year end. Both determine how much headroom actually remains.