Covenants
By SuperdayReps · Wharton MBA · ex-Greenhill · investment banking interview coaching
8 min read · updated October 7, 2026
A loan is a bet that the company will still be able to pay in five years. Lenders cannot watch the business every day, so they write rules into the loan agreement that act as tripwires: if the company's numbers get worse past a set point, the lenders get a say before things get worse still. Those rules are covenants, and in restructuring they are often the first thing to go wrong.
The point of a covenant is not to catch the company out. It is to bring the lenders back to the table early, while there is still value to protect, instead of finding out about the problem when the company misses a payment.
Two kinds of test
Every financial covenant is one of two types, and the difference decides whether a bad quarter is a crisis or a non-event.
| Maintenance covenant | Incurrence covenant | |
|---|---|---|
| When it is tested | Every quarter, whatever the company does | Only when the company tries to act |
| Typical test | Debt / EBITDA below 5.0x, EBITDA / interest above 2.0x | Can it borrow more, pay a dividend, make an acquisition? |
| What failing means | Default | The action is blocked; no default |
| Where you find it | Bank loans, private credit, revolvers | High-yield bonds, covenant-lite loans |
A maintenance covenant is tested every quarter. If EBITDA falls and the leverage ratio drifts above the limit, the company is in breach even though it did nothing. The two classic tests are maximum leverage (debt divided by EBITDA) and minimum interest coverage (EBITDA divided by interest).
An incurrence covenant only bites when the company does something. A high-yield bond might say the company can only take on new debt if, after borrowing, its earnings would still cover its fixed charges at least 2.0x. If a bad year pushes the company below that, nothing happens: it simply cannot use that route to borrow more, or pay its owners a dividend, until it recovers.
The same number can mean opposite things. A company at 6.5x leverage under a 5.0x maintenance covenant is in default. The same company at 6.5x with only a 5.0x incurrence covenant is in no trouble at all with its lenders; it just cannot borrow more or pay dividends through the ratio until it is back under. Always ask which kind of covenant it is before saying what happens.
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Frequently asked
- What is the difference between a maintenance covenant and an incurrence covenant?
- A maintenance covenant is tested every quarter whatever the company does, so if leverage drifts above the limit because earnings fell, the company is in default. An incurrence covenant is only tested when the company tries to act, such as borrowing more or paying a dividend. Missing an incurrence ratio is not a default; it just blocks the action. Bank loans tend to carry maintenance tests, while high-yield bonds and covenant-lite loans rely on incurrence tests.
- How do you calculate covenant headroom?
- Find the EBITDA at which the company would just hit the limit, then compare it with today's EBITDA. With $500M of debt and a 6.0x leverage covenant, the floor is $500M / 6.0 = $83.3M. If EBITDA is $100M today, it can fall $16.7M, or about 17%, before the company breaches.
- What is an equity cure?
- A right that lets the owner fix a failed covenant test by putting in new equity, which usually counts as extra EBITDA for that test. It is limited: typically no more than two cures in any four quarters and about four over the life of the loan, and only the amount needed to pass. It buys time; it does not fix the business.
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