Debt Covenants Explainer
Debt covenants are contractual promises that require or restrict borrower behavior. Affirmative covenants may require financial reporting, insurance, taxes, and asset maintenance. Negative covenants may limit additional debt, liens, asset sales, acquisitions, investments, or distributions. Financial covenants test measures such as leverage, coverage, or minimum liquidity.
Covenants protect the lender’s agreed risk position after funding. The agreement defines calculations, reporting dates, baskets, exceptions, cure rights, and consequences of breach. Borrowers negotiate operating flexibility so ordinary decisions do not require repeated lender consent.
A breach can trigger an event of default, increased pricing, a waiver request, or renegotiation. Lenders may use the moment to obtain information, collateral, repayment, or revised terms. Many breaches are cured or waived rather than leading immediately to acceleration.
The headline ratio is only as strong as its definitions. EBITDA adjustments, debt exclusions, unrestricted subsidiaries, transferred assets, permitted liens, and grower baskets can materially change protection. Borrowers should forecast compliance under downside cases, while lenders should test how much capacity exists before the covenant actually constrains behavior.
Affirmative, negative, and financial covenants preserve the negotiated risk profile.
Exceptions create practical flexibility.
Default rights can lead to waiver, amendment, repayment, or enforcement.
Acceleration is not automatic in every case.
Adjustments and baskets can expand capacity far beyond the headline test.
Model the document, not just the ratio.
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