Maintenance covenants are regular, scheduled financial tests that a borrower must meet quarter after quarter. By contrast, incurrence tests switch on only when the borrower takes specific actions such as raising new debt or paying a dividend. In European mid-market private credit, the anchor test is usually net leverage – net debt divided by EBITDA under agreed definitions – because it spots stress early and ties directly to deleveraging capacity.
This guide explains how maintenance covenants work in sponsor-backed deals, what definitions decide outcomes, and how to design tests that detect underperformance without blocking sensible growth moves.
Where covenants sit and who relies on them
In sponsor-backed mid-market deals under English-law Senior Facilities Agreements, covenants live in the SFA, interact with the intercreditor, and sit above security documents. The covenants bind the restricted group, which is set by guarantor coverage and any local law limits on upstream guarantees. Because private companies disclose little publicly, covenants create a private reporting regime that substitutes for market transparency.
Private credit funds lead most deals, often alongside banks that provide a super-senior revolving credit facility. A small club structure tightens monitoring and speeds decisions, improving both risk management and close certainty. Sponsors push for flexible definitions, add-backs, headroom, and cure rights. Lenders push for early triggers, clean information, and consistent math across periods.
How the core leverage covenant works
Definition and placement
A quarterly-tested net leverage covenant at the top of the capital structure is market. The formula is mechanical: net financial indebtedness (gross debt less eligible cash) divided by defined EBITDA. Trapped cash, pledged balances, and customer deposits are usually excluded from cash. EBITDA includes detailed add-backs and pro forma adjustments that the parties cap and time-limit.
Testing cadence and deliverables
Tests run quarterly off quarter-end financials synced to the borrower’s fiscal calendar. Management delivers a compliance certificate signed by a senior officer, with ratio math, add-back schedules, and pro forma steps, within the agreed timeframe. Lenders increasingly customize the certificate to require EBITDA reconciliations, net debt bridges, and disclosure of achieved versus projected synergies.
Headroom, steps, and acquisition flex
The opening level includes cushion versus plan and may step down over time as deleveraging is expected. Temporary step-ups for acquisitions can apply above a size threshold, usually with a defined look-forward window for synergies. Lenders want the model to clear a sensible downside; sponsors want space for bolt-ons and post-close integration.
Cure mechanics and guardrails
Equity cures are standard and typically work either through cash prepayment that reduces net debt or a deemed EBITDA increase for covenant purposes. Frequency caps, no back-to-back usage, and carryforward rules are negotiated; many lenders now cap EBITDA cures and limit their use to leverage breaches only. For deeper context on market practice, see a primer on equity cure provisions in leveraged finance.
Cross-triggers, events of default, and control
A leverage breach becomes an event of default after any cure or delivery grace period. Intercreditor terms often prioritize the super-senior RCF in enforcement decisions and control periods. If a bank-led RCF includes a “springing” covenant, it typically tests only when drawings exceed a threshold and can be tighter than the borrower-level leverage test. For practical enforcement levers, see this overview of intercreditor agreements and lien subordination.
Secondary tests you may see
Earnings-based add-ons when interest or cyclicality bites
- Interest coverage: Useful where cash interest burden is material or earnings are cyclical; most deals use cash interest to avoid accounting noise.
- Liquidity minimums: Frequent in recurring revenue loans with negative or transitioning EBITDA; defined as unrestricted cash plus undrawn RCF, net of letters of credit.
- DSCR: Appears in infrastructure-adjacent or asset-heavy credits with amortizing cash flows; unusual in mainstream corporate unitranche facilities.
Recurring revenue loan frameworks
Early-stage software and tech-enabled services often run on net debt to ARR, with a glidepath to EBITDA-based covenants as profitability matures. ARR definition – gross vs net, credits, and churn – is heavily negotiated. Underwriting tracks gross and net dollar-based retention, logo churn, and customer concentration; these inform undertakings while the anchor covenant remains leverage for predictability. A minimum liquidity covenant backstops burn, and the springing RCF test should dovetail with the floor to avoid double counting.
Definitions that move the ratio
- EBITDA add-backs: Include non-recurring costs, extraordinary items, deal costs, restructuring, and non-cash charges. Pro forma adjustments for M&A and identified cost synergies are capped and time-bound, with required deliverables like board-approved plans or third-party support.
- IFRS 16 leases: Lease capitalization complicates net debt and interest. Market practice excludes IFRS 16 lease liabilities from net debt and uses cash interest in coverage tests. Some lenders permit treating lease payments as operating expense for EBITDA consistency.
- Non-controlling interests and JVs: Align EBITDA and debt via proportional inclusion or carve-outs. Do not include JV EBITDA without the corresponding share of JV debt.
- Securitization and factoring: Exclude only genuinely non-recourse programs that meet strict criteria; otherwise include them in net debt to prevent off-balance-sheet leverage. Supply-chain finance needs explicit treatment given its debt-like behavior.
- Cash definition: “Cash and Cash Equivalents” typically excludes trapped cash, pledged cash, and amounts not freely upstreamable. Jurisdictional constraints can make headline cash misleading; ensure the definition matches operational reality.
Baskets, ratio debt, and local facilities
Grower baskets – “greater of” constructs – scale with EBITDA, assets, or revenue and can overlap with ratio-based capacity. Ratio debt tied to leverage allows more borrowing if EBITDA grows through add-backs rather than cash, so lenders counter with tighter definitions of credit facility debt, limits on pari capacity, and guardrails against structural seniority. Working capital lines, leases, and overdrafts fit within limits, but oversized local lines dilute collateral and complicate sweeps; size them within covenant headroom.
Documentation and voting map
Term sheets set the covenant pack early: tests, levels, step-downs, cure design, springing mechanics, and key definitions. The Senior Facilities Agreement follows LMA leveraged templates, with covenants in a dedicated clause plus a schedule for pro forma mechanics. Intercreditor terms define consent thresholds for waivers or resets, standstill timing, and super-senior carve-outs. A leverage waiver typically needs a majority lender vote; if the RCF springing test trips, super-senior lenders often hold enhanced rights during standstills. Documents should also prevent any single cure from counting twice across tests.
Information discipline and modeling
- Reporting cadence: Quarterly compliance certificates with ratio math, add-back schedules, and pro forma leverage; monthly liquidity reporting where relevant. Annual audits, quarterly management accounts, and event-driven reports for acquisitions are standard.
- RRL KPIs: Use dashboards for ARR, retention, cohorts, and churn; lenders may reserve the right to seek auditor comfort on adjustments above a threshold.
- Accounting stability: Use “frozen GAAP” or consistent reporting clauses so you can compare periods cleanly.
- Model hygiene: Build structured add-back schedules, synergy trackers, and net debt reconciliations; log every assumption change and tie it to documentation.
Economics and restrictions linked to leverage
Margin ratchets link pricing to leverage. A covenant breach can trigger margin step-ups, default interest, or distribution limits. Align the ratchet’s leverage definition with the maintenance definition to avoid mismatches. Amendments and repeated cures often carry fees, and distribution capacity typically keys off leverage tests; a breach usually shuts off dividends and leverage-dependent baskets.
Governance, enforcement, and early remediation
Most direct lenders operate under AIFMD-style governance with KYC and sanctions obligations that sit beside financial undertakings. Missed information undertakings can escalate independent of performance. Maintenance covenants surface issues before liquidity pinches, enabling amendments, tighter reporting, added milestones, or external advisors. English-law share pledges and receivership provide credible remedies; intercreditor standstills protect the super-senior RCF and organize process. In civil law jurisdictions, enforcement friction puts a premium on early negotiation.
Market context and product norms
US broadly syndicated loans are often covenant-lite. European private credit usually keeps at least one maintenance test at borrower level, reflecting private markets, less liquid pricing signals, and a preference for document control. High-yield bonds rely on incurrence covenants and cannot deliver quarterly headroom checks, so larger, rated issuers may choose bonds for scale while mid-market issuers lean on private credit.
- Unitranche: Single net leverage covenant at borrower level, often with a springing RCF covenant; equity cures allowed with caps and frequency limits. For structures and pricing, see unitranche loans.
- Senior/second-lien: The leverage covenant sits at senior; second-lien does not run a separate maintenance test and cannot control ahead of senior during standstills. Learn more about second-lien loans.
- Holdco PIK: Often no maintenance covenant at holdco; protection comes from structural subordination and upstream restrictions. See holdco PIK notes.
- RRLs: ARR-based maintenance with a transition to EBITDA and a minimum liquidity floor. For common structures, review recurring revenue loans.
Quick negotiation pressure points
- EBITDA add-backs: Cap aggregate add-backs, time-limit synergies, and require documentary support. If opening compliance needs outsized add-backs, reset the covenant or the cap.
- IFRS 16 alignment: Ensure EBITDA and net debt treatments match; use cash interest for coverage tests.
- FX mechanics: Add constant-currency or testing-currency provisions when revenue and debt differ by currency.
- Hidden leverage: Limit exclusions for securitizations, supply-chain finance, or local debt to genuinely non-recourse structures; require transparent reporting.
- JVs: If JV EBITDA is included, include proportional JV debt or cap JV EBITDA.
- Cures: Cap frequency within any four-quarter period and block consecutive EBITDA cures that mask structural declines.
- Springing thresholds: If the RCF trigger allows material drawings without a test, lower it or use average-utilization triggers to deter window dressing.
Timeline to implement
- Weeks 0-2: Agree the covenant pack at term sheet; credit teams run downside cases, set headroom, and log definitional essentials.
- Weeks 2-6: Draft SFA covenants and definitions; borrower finance builds a covenant model aligned with accounting policies; finalize springing mechanics and intercreditor alignment.
- Weeks 6-8: Lock the compliance certificate format; define auditor comfort scopes for future pro formas if needed; legal opinions address enforceability and local guarantee limits.
- Post-close: Monthly calls, quarterly tests, and dashboards track EBITDA add-backs, net debt reconciliations, ARR metrics where relevant, and usage of baskets and cures.
Operational pitfalls to avoid
- Definition mismatch: Misaligned leverage definitions between margin ratchets and maintenance tests create warped incentives; align them.
- Overstated cash: Trapped or pledged balances inflate headroom; define cash narrowly and report trapped amounts by jurisdiction.
- Supply-chain finance: Treat obligations as debt unless strictly trade; otherwise free cash flow is overstated.
- Deferred consideration: Count earn-outs and vendor loans as debt once payable; do not let due dates just after quarter-end slip through.
- Cure carryforward: Ring-fence for testing only and exclude from builder baskets to avoid inflating distribution capacity.
Fresh angle: a practical early-warning dashboard
Teams that avoid surprises track three simple leading indicators alongside the headline covenant. First, monitor run-rate EBITDA after stripping all add-backs above a small threshold; the “clean EBITDA” trend is the canary. Second, reconcile net debt monthly with a working-capital walk and a separate schedule for supply-chain finance, receivables sales, and FX effects. Third, overlay a rolling 13-week liquidity forecast against a hard minimum that is tighter than the document floor to absorb noise.
- Rule of thumb: If your downside case adds 0.5x to net leverage on a 10 percent EBITDA drop, your headroom is thin – recheck steps and cures before signing.
- Constant currency: When FX is volatile, run a test deck in the testing currency to see if conversions, not operations, drive the ratio; plug that gap in definitions.
- DDTL alignment: If you expect multiple acquisitions funded by delayed draw term loans, pre-wire temporary step-ups, synergy evidence, and reporting cadence in the term sheet.
Recent market read
Across 2024, European direct lending kept meaningful financial covenants in place. The dominant setup remains a single net leverage test, typically paired with a springing RCF covenant and disciplined cure mechanics. Pressure has moved to EBITDA elasticity and the breadth of grower baskets, not the existence of a covenant. Diligence now concentrates on definitions and reporting so the test reflects economic reality rather than spreadsheet optimism.
Key Takeaway
Definitions, not slogans, protect capital. Get the math right, test it often, and insist on clean reporting. Pricing, headroom, and cures tend to fall into place when everyone can see the same numbers at the same time.