Financial Covenants in Private Credit: Key Types and Downside Protection

Financial Covenants in Private Credit: 2025 Playbook

Financial covenants convert operating data into early decision rights. They measure leverage, coverage, or liquidity against set thresholds, and, when crossed, they let lenders act before cash drains and collateral thins out. In practice, they are early-warning beacons that push issues to the table while there is still time to fix them.

The payoff is simple. Well-designed maintenance tests create options earlier, keep value inside the ring fence, and turn a tough quarter into a controlled course correction rather than a scramble. In a higher-rate environment with sponsor documentation evolving fast, the difference between good and weak covenant architecture shows up quickly in recoveries.

Why maintenance beats incurrence when the cycle turns

Private credit relies on maintenance covenants, usually tested quarterly on actual results, while broadly syndicated loans often lean on incurrence tests that only apply when a borrower takes a new action such as raising debt. That split matters in a rough patch. Maintenance tests allow lenders to tighten leakage, dial up cash controls, and negotiate resets while there is still headroom. The result is earlier control and better recovery odds.

Market practice reflects this divergence. Covenant-lite still dominates the large U.S. syndicated market. Private credit has moved the other way. unitranche loans and senior stretch facilities typically include maintenance leverage or interest coverage and often a springing minimum liquidity test. Equity cures exist, but lenders now add tighter rails. The logic is practical: when a plan misses, maintenance tests force a constructive fix rather than a rushed restructuring.

Choose tests that map to the cash engine

The right covenant suite aligns with how the business generates and consumes cash. The goal is a test that trips soon enough to act, but not so tight that it creates false alarms.

Maximum leverage: Net debt over EBITDA, sometimes first-lien or senior-only. Specify cash netting rules, trapped cash, capitalized leases, and letters of credit. Impact: earlier signal on debt load, immediate negotiation on breach.
Interest coverage: EBITDA over cash interest. Useful when rates bite. Include commitment fees and any PIK interest that toggles to cash. Impact: rate risk visibility and quicker margin resets.
Fixed charge coverage (FCCR): EBITDA minus maintenance capex over cash interest, scheduled amortization, and taxes. Best for asset-heavy models with unavoidable spend. Impact: cash obligations front and center.
Debt service coverage (DSCR): Cash flow available for debt service over required service. Suits project-style or asset-based setups. Impact: fits contracted cash flows and clarifies prepayment path.
Minimum liquidity: Unrestricted cash plus undrawn committed revolver availability. Often springing when the revolver is drawn over a threshold or when cash dips. Tie to blocked accounts and dominion. Impact: faster intervention and lower loss severity.
Minimum asset coverage: More common in ABL and NAV facilities. Tests the borrowing base with haircuts, concentration limits, and eligibility rules. Impact: direct collateral health check.

Borrower profiles dictate the mix. Recurring revenue software often pairs minimum liquidity with ARR-based tests. Asset-light services with seasonality use leverage plus liquidity. Asset-heavy platforms favor FCCR or DSCR because EBITDA add-backs can hide tomorrow’s cash needs.

Definitions decide outcomes at signing

EBITDA: cap the creativity

Start with GAAP or IFRS operating income plus depreciation and amortization. Add non-recurring charges and restructuring costs only with hard caps. Tie synergy add-backs to board-approved plans with milestones and proof. Distinguish realized from to-be-realized within a fixed window and demand evidence. This reduces disputes and keeps headline leverage honest.

Pro forma treatment should include acquisitions and divestitures only if closed or contractually committed, ban double counting, and require consistency with the sponsor model. State how IFRS 16 and ASC 842 impact EBITDA and interest, and decide whether lease interest sits in coverage tests so there are no surprises when rates move. Normalize FX gains and losses, and anchor extraordinary items to accounting standards to avoid subjectivity.

Net debt: guard against faux deleveraging

Limit cash netting to unrestricted cash in controlled accounts. Exclude trapped, pledged, or foreign cash with withholding or sanctions friction. Consider caps or minimum liquidity baskets to avoid circular math. Include debt-like items such as drawn LCs, finance leases, seller notes, earnouts with debt characteristics, PIK, and securitizations that rely on group cash flows. Only include mark-to-market on interest hedges if termination is mandatory on default to avoid noise.

Guarantor coverage and the restricted group

Set guarantor EBITDA or asset coverage at 80 to 90 percent. If local law limits guarantees, offset with security, cash sweeps, or other protections. Draw the restricted group perimeter tightly. Use hard caps on unrestricted subsidiaries and add blockers that deem core IP and material assets off-limits to transfer to prevent value leakage.

Make springing covenants and cash controls count

A super-senior revolver often carries a springing leverage, coverage, or liquidity test that switches on at a set draw or when liquidity falls below a floor. When on, breaches matter; when off, the test sleeps. Good documents connect springers to blocked accounts and dominion so lenders can manage cash as soon as signals flash. This delivers earlier throttle on spending and clearer enforcement.

For a deeper overview of springing covenants and core maintenance tests, align any springer with the term loan’s primary maintenance covenant to reduce orphan breaches that create noise without actionability.

Headroom, ratchets, and rate risk discipline

Set initial headroom wide enough to account for base-case wobble and a reasonable downside. Typical leverage headroom runs 0.5 to 1.0x above the low case in year one, then steps down. Avoid margin ratchets that back-solve to razor-thin cushions that trigger price jumps in a downturn. In a higher-rate regime, interest coverage earns its keep by forcing dialogue before cash interest spikes crowd out growth capex.

Equity cures: use them, but fence them

Cures can come as cash that repays debt or sits as restricted cash, or as EBITDA cures that deem EBITDA higher for the quarter. The former is cleaner. The latter can inflate ratios if not contained, which is why lenders now tighten form, frequency, and leakage rules. For deeper background, see this explainer on Equity Cure Provisions in Leveraged Finance.

Frequency limits: Cap cures per rolling four quarters and over the life of the loan.
No overcures: Ban headroom stockpiling through overfunding.
Quarter specific: Apply cures to a specific quarter only, with narrow carryforward rules.
Leakage block: Prevent EBITDA cures from feeding leverage-based basket capacity.
Cash use: If cash cures repay debt, apply pro rata across pari debt and prepay the revolver first to free liquidity.

Information rights and calculation mechanics

Compliance certificates should include a full EBITDA bridge with add-backs by category, a debt schedule, and a cash reconciliation. Borrowers deliver quarterly and monthly management accounts with variance analyses. Lenders reserve rights to review backup for add-backs and synergy realization, escalating to a consultant at the borrower’s expense after a headroom trigger. Use frozen GAAP, or equivalent neutralizing adjustments, so accounting changes do not soften covenants. If policy shifts are material, allow a defined recast window with no default during the fix.

Consent architecture and waterfall triggers

A maintenance breach should automatically restrict dividends, junior debt payments, acquisitions, and investments until headroom is rebuilt. For ABL or NAV-style facilities, spring cash dominion and re-determine borrowing bases. Expect negotiated resets: waivers in exchange for margin, amortization, tighter baskets, board observers, and reporting upgrades. If a breach goes uncured, it becomes an event of default that supports acceleration. Align cross-defaults so they do not set off chain reactions that kill optionality. For context on contract drafting, see an overview of cross default clauses.

Leakage and liability management protections

Restricted payments: Tie capacity to consolidated net income builders or fixed baskets, not EBITDA-only math. Ban capacity build from EBITDA cures and require no default bring-down plus pro forma compliance.
Investments and transfers: Cap investments in unrestricted subs and non-guarantors with hard-dollar or small grower baskets. Use fair value and, for larger moves, third-party valuations.
Drop-down blockers: Name protected IP, brands, and core assets and ban transfers. Add J.Crew-style blockers that deem them material.
Uptiering and priming: Make pro rata sharing a sacred right. Tighten open market purchase definitions to prevent non-pro rata exchanges. Require majority-of-each-tranche consent for priming liens.

Cash controls that work in practice

Blocked accounts: Turn on account control agreements upon liquidity breaches or revolver draws above set levels and confirm enforceability in every jurisdiction.
Cash sweeps: Calibrate excess cash flow sweeps to delever in downturns without starving working capital. Tie sweep percentages to leverage tiers rather than calendar dates.

Recurring revenue and venture-style credit

When EBITDA is negative or volatile, focus on durability of revenue and runway instead of profitability.

Minimum ARR: Define contracted revenue tightly, net of credits and discounts, and include logo retention and gross churn.
Minimum liquidity and runway: Track months of cash burn with cures limited to new equity or committed delayed-draws.
Efficiency metrics: Use burn multiple or rule-of-40 as observation triggers that step up reporting or budget controls, not defaults.
Conversion covenant: Pre-wire the transition to EBITDA-based covenants once the business crosses into positive EBITDA, with cushions set at signing.

Intercreditor dynamics: clarity on who decides when

In unitranche structures, first-out lenders often control actions for payment defaults and some financial covenant breaches. Last-out lenders want veto rights for restructurings that hit economics. Super-senior revolver lenders usually gain control on liquidity or borrowing base breaches. Any change to financial covenants should need consent from the controlling class plus any affected classes. Where multiple facilities sit side by side, align tests to avoid orphan breaches that only trip one silo. For deeper drafting guidance, see practical notes on intercreditor agreements.

Jurisdiction notes that avoid execution risk

New York law facilities rely on UCC security and need fraudulent transfer diligence for upstream guarantees and cash cures. English-law deals lean LMA but flex toward private equity terms. In Europe, super-senior revolvers with springing covenants often sit over unitranche term loans, and Germany and France bring financial assistance and corporate benefit limits handled via whitewash or limitations language. Align documentation so local limits do not create holes in guarantor coverage or cash control.

Economics of waivers and resets

When a test is missed, lenders price consent. Expect ratable fees with step-ups if leverage stays high for multiple quarters, margin bumps for a defined period, added amortization or mandatory prepayments from excess cash or asset sales, tighter baskets, and liability management blockers if missing. Board observer rights and upgraded reporting usually join the package. Define measurement dates, notice periods, and cure windows precisely, and do not allow retroactive rescoring. For large add-backs, require auditor comfort or agreed-upon procedures.

Accounting discipline and add-back verification

Align the restricted group to consolidated reporting. If JV EBITDA gets counted, cap it and require audited statements. Lock policies through frozen GAAP or provide neutralizing adjustments for changes that inflate EBITDA. Require annual audited financials without going concern flags, except for maturities within 12 months that will be refinanced under committed facilities. When liquidity tests apply, deliver rolling 13-week cash flow and monthly covenant forecasts after a trigger. For definitional precision, align with market practice on EBITDA add-backs.

Implementation: assign owners and build a rhythm

Term sheet: Agree the suite, headroom, test frequency, and reporting. Settle major definitions early.
Documentation: Lender counsel drafts covenants, cures, and blockers; borrower counsel negotiates caps and carve-outs.
Modeling: Run downside cases on headroom; obtain independent QofE to validate adjustments and synergies.
Closing: Finalize guarantor coverage, collateral perfection, and account control agreements. Lock the compliance certificate form.
Post-close: Complete the first compliance cycle within 45 to 60 days of quarter-end and baseline trackers for consistency.

Quick kill tests that flag weak protection

Cure overuse: If a borrower can cure every quarter and cures feed builder baskets, protection is thin.
Unrestricted subs: If unrestricted subs have more than de minimis capacity without leverage tests and fair value opinions, drop-down risk is high.
Unlimited add-backs: If EBITDA add-backs lack caps, evidence standards, and timelines, expect erosion.
Sacred rights gaps: If sacred rights do not protect pro rata sharing, priming, and open market purchases, liability management risk remains.
No dominion: If minimum liquidity does not trigger cash dominion, enforcement may lag cash burn.

Comparisons that guide the choice

Leverage vs. FCCR: Leverage trips earlier in asset-light cyclicals; FCCR captures hard cash needs in asset-heavy names.
Interest coverage vs. DSCR: Coverage tracks rate risk; DSCR matters when amortization bites.
Liquidity vs. leverage: Liquidity triggers are more actionable in fast-burn situations.
ARR vs. EBITDA: For growth SaaS, ARR aligns with unit economics; convert to EBITDA tests as the model matures.

What good looks like in 2025

A solid private credit package includes quarterly maintenance leverage with sober headroom and a paired springing liquidity test, EBITDA definitions with hard add-back caps, synergy deadlines, and verification triggers, equity cures that are limited and do not fuel basket capacity, protections against non-pro rata uptiers and drop-downs with tight unrestricted sub limits, sacred rights that require all affected lenders to consent to financial covenant changes, and intercreditor terms that align springers, dominion, and term loan maintenance tests. None of this replaces diligence or collateral. It simply puts a clock and a rulebook around the moment you need to act.

Diligence focus and recordkeeping

Treat covenant math like audit evidence. Keep an archive of compliance certificates, calculation workpapers, Q and A, user access, and full audit logs. Hash final packages, set clear retention periods, and seek vendor deletion with a destruction certificate when the window closes. Legal holds override deletion. This discipline shortens negotiations in tense markets and reduces friction with auditors and regulators.

Conclusion

Covenants do not predict outcomes. They create earlier choices. Used well, they turn a wobble in results into a controlled reset instead of a scramble, which is the difference between preserving enterprise value and watching it leak away.