Covenant
Private Credit glossary · Documentation, Covenants & Terms
Definition
Contractual restriction governing borrower behavior, split into three types: (i) affirmative (actions the borrower must take — deliver financials, maintain insurance), (ii) negative (actions prohibited without lender consent — additional debt, dividends, asset sales, liens), and (iii) financial (quantitative tests like leverage and FCCR). In credit theory, financial covenants are modeled as a down-and-in barrier option (Black-Cox) — empirically worth sim 80–120 bps of spread on a typical 5–6× unitranche.
Covenant in plain English
A covenant is simply a rule written into a loan contract about how the borrower must behave, and there are three flavors: things they MUST do (send financial reports, keep insurance), things they must NOT do without permission (take on more debt, pay owners, sell off assets), and numeric health tests they must PASS (keep debt and interest coverage within limits). These rules protect the lender by catching trouble early and forcing a conversation before a company slides off a cliff. Finance theory treats a numeric covenant like an alarm that trips the moment a company crosses a danger line, and in practice that protection is valuable enough to be worth roughly an extra 0.8 to 1.2 percent of yearly interest — meaning lenders will accept a slightly lower rate in exchange for having those alarms in place.
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