Covenant
Investment Banking glossary · Restructuring (RX), DCM, & ECM
Definition
Contractual restriction on a borrower in a credit agreement. Maintenance covenants are tested quarterly against a financial threshold (e.g., Total Debt/EBITDA ≤ 5.0×, Interest Coverage ≥ 2.0×) and a breach triggers default even with no action by the borrower. Incurrence covenants are tested only when the borrower takes a specified action (issue debt, pay a dividend, make an acquisition) and require the borrower to demonstrate compliance pro forma. Maintenance covenants typically use declining leverage thresholds and increasing coverage thresholds over the term, reflecting expected deleveraging.
Covenant in plain English
A covenant is just a promise a company makes to its lenders in exchange for borrowing money — a set of house rules to reassure the bank it will get paid back. There are two flavors. A "maintenance" covenant is like a report card the company must pass every quarter: it has to keep certain ratios in a safe zone (say, its total debt no more than 5 times its yearly earnings, or its earnings at least 2 times its interest bill), and simply failing the test counts as breaking the loan — even if the company did nothing risky. An "incurrence" covenant is gentler: it only kicks in when the company wants to do something bold, like borrow more, pay owners a cash reward, or buy another business, and then it must prove it would still be healthy afterward. Lenders often tighten the maintenance targets over time because they expect the company to pay down debt as the years pass.
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