Capital & Financing

Incurrence versus Maintenance Covenants

One covenant tests the borrower every quarter whether or not anything happens. The other only tests it when the borrower wants to do something. Knowing which you have decides when anyone finds out there is a problem.

  • Advanced
  • 12 min total
  • 13 chapters

What decision this helps you make: Which covenant architecture a facility should have, what a maintenance covenant is genuinely worth to a lender, and how much of a covenant's protection survives the definition of EBITDA it is measured against.

What this topic is

A maintenance covenant is a financial ratio the borrower must satisfy at every test date, typically quarterly, regardless of what it does. An incurrence covenant is a ratio the borrower must satisfy only at the moment it takes a specified action: incurring debt, making a restricted payment, making an acquisition, or granting a lien. Passing an incurrence test is a condition to acting; failing a maintenance test is an event of default.

Why it matters

The difference decides when a lender gets a seat at the table. A maintenance covenant gives lenders a contractual right to renegotiate while the business still has enterprise value and options. An incurrence-only package gives them nothing until a payment is missed or the borrower needs something, which in practice means years later and at a lower value. The shift of the institutional loan market to covenant-lite is the single largest structural change in leveraged credit of the last two decades, and its consequences are still being argued about.

Who should learn it

Credit investors and direct lenders assessing document quality, sponsors and CFOs negotiating a package, and anyone who has to explain to an investment committee why two loans at the same leverage are not the same risk.

What you will understand

  • Exactly how each covenant type is tested and what failing it triggers
  • Why the definition of EBITDA does more work than the covenant level
  • What the evidence says about covenant-lite and recoveries, and where it is genuinely contested
  • How to read a covenant package in the order that finds the weaknesses fastest

Prerequisites

Common misconception

"Covenant-lite means no covenants." It does not. A covenant-lite loan has a full set of negative covenants (restrictions on debt, liens, restricted payments, asset sales, investments and affiliate transactions) and they are enforceable. What it lacks is a financial maintenance covenant on the term loan. The distinction matters because the negative covenants are all incurrence-based: they constrain what the borrower chooses to do. Nothing in a covenant-lite package constrains a business that is simply getting worse. Deterioration is not an action, so it does not trip anything.