Structuring Financial Covenants for PE Sponsors: Levels, Headroom, Cure Rights

Financial Covenants in Private Credit: A Practical Guide

Financial covenants are ongoing ratio tests in a loan that indicate when leverage or coverage has crossed a line. Maintenance covenants test these ratios at set dates no matter what the borrower does, while incurrence covenants test only when the borrower takes certain actions, such as raising debt or paying dividends. Think of them as early warning lights and steering knobs on the same dashboard, guiding lenders and sponsors to act before options disappear.

What sponsors want is room to run the playbook – operate, buy add-ons, and refinance when the timing is right. What lenders want is an early call if performance drifts and the practical ability to act while choices remain. Today’s market splits along that fault line: broadly syndicated loans lean on incurrence-only packages and, at most, a springing revolver test, while private credit still uses one or two maintenance tests, albeit with looser definitions and cure features.

The covenant toolkit: maintenance vs incurrence

Maintenance tests act like a quarterly health check that must be passed regardless of corporate activity. Incurrence tests are event driven and only apply when the borrower takes specified actions. The right balance depends on cash flow stability, working capital volatility, and sponsor strategy.

Private credit typically favors a single maintenance test for clarity and speed. In contrast, BSL packages are mostly covenant lite and rely on incurrence tests, supported by a springing revolver covenant that activates only when liquidity usage rises.

Where the test lives: core architecture choices

Private credit deals usually carry a single maintenance test on first-lien net leverage, tested quarterly, often with step downs. Some add a minimum interest or fixed charge coverage ratio where cyclicality or working-capital swings are real. Mid-market unitranche loans often use an AAL to split first-out or last-out economics, with the maintenance test binding the borrower across tranches for enforcement clarity.

BSL packages are mostly covenant lite. Any springing test applies to the RCF only and turns on when the revolver crosses a draw threshold, commonly 35 to 40% of commitments net of cash and letters of credit. The metric is typically first-lien net leverage, set well above opening term loan leverage to protect liquidity access while preserving discipline. Europe follows LMA-style structure but, like the US, has embraced grower baskets, ratio debt, and longer EBITDA add-back windows.

Get the math right: ratio definitions that drive economics

Debt: define what counts

Debt definitions determine whether the numerator balloons in a downturn. Sponsors push to exclude operating leases, contingent earnouts, non-recourse debt at unrestricted subs, and purchase price holdbacks. Lenders push to include finance leases, drawn LCs, guarantees, and seller notes that behave like senior debt. Accounting changes that move leases onto the balance sheet can inflate EBITDA and debt. Most agreements fix accounting at a date with frozen GAAP or neutralize changes so compliance does not swing based on standards.

Net debt: calibrate cash netting

Cash rules matter. Sponsors want broad netting, including foreign cash. Lenders cap netting to unrestricted, readily available, and often perfected cash, excluding restricted or hard-to-upstream balances. If the structure allows second-lien or unsecured capacity, define both first-lien and total leverage and align them with incremental and ratio debt sizing so capacity cannot creep without tripping tests. Where junior capacity is expected, it is also worth understanding second-lien loans and their treatment in leverage tests.

EBITDA: control the battleground

Start with audited EBITDA and add back non-cash charges, one-time restructuring, and run-rate synergies from acquisitions or cost actions. The window for synergy add backs has stretched from 18 to as much as 24 to 36 months in many deals. Caps and certification standards vary, with European deals more often requiring savings to be reasonably identifiable and supportable. Many lenders now cap add backs as a percentage of LTM EBITDA to protect model integrity. For further context on what qualifies, see this overview of EBITDA add-backs.

Set levels and headroom with downside in mind

Set levels to the realistic downside, not the marketing case. Build a quarterly downside path with revenue shock, margin pressure, and delayed cost saves. Use LTM for quarterly testing where seasonality is meaningful, because LQA can mislead after unusually strong or weak quarters. Tie step downs to free cash flow inflection, since if they step down too early, headroom shrinks before liquidity improves.

Practical screens many underwriters use include:

Day-one cushion: Headroom that survives a 15 to 25% EBITDA miss over the next year without cures and 25 to 35% with cures.
Leverage buffer: At least 1.0 to 1.5 turns of cushion to the first step down on defined metrics, not GAAP.
Synergy haircut: Haircut realization in the model and assume slippage and delays.

Design the equity cure valve, not just the handle

An equity cure lets sponsors add capital after a failed test to return to compliance. The form and limits shape the outcomes.

Form of cure: Paying down debt lowers the numerator. Deeming the cure as EBITDA helps more per dollar but can distort optics. If allowed, cap EBITDA cures and separate them from capacity that grows with EBITDA.
Frequency and caps: Limit cures per year and over the life and avoid back-to-back quarters. For EBITDA cures, cap as a percentage of LTM EBITDA, and do not let ordinary sponsor equity for an acquisition consume cure capacity.
Carry-forward: If unused cure amounts carry forward, state that EBITDA cures do not increase capacity for restricted payments, investments, incremental sizing, or pricing ratchets.
Timing and documentation: Set a window of 10 to 20 business days after notice. Allow the cure after quarter end but before the compliance certificate is due, with a short window to fix good faith errors.
No double count: Prevent the same cure dollar from both reducing debt and boosting EBITDA.

Springing RCF covenant: build a shock absorber

For BSL borrowers, the revolver bridges working capital, so the test should protect access without turning seasonal draws into technical issues.

Trigger base: Use outstanding revolver loans net of readily available cash, not just a percentage of commitments. Carve out LCs and swingline where they do not represent cash usage.
Metric selection: First-lien net leverage is standard. Add interest coverage where working capital swings whipsaw net leverage.
Cure coverage: Ensure equity cures apply to the springing covenant to avoid avoidable stress during temporary draws.
Testing cadence: Quarterly testing at fiscal quarter end once triggered provides stability. Weekly testing is noisy and operationally heavy.

Incurrence interactions: align the system

Most sponsor flexibility lives in incurrence baskets, so align definitions across maintenance and incurrence tests to avoid churn and amendments. A ratio debt basket that uses a looser EBITDA definition than the maintenance test is a recipe for confusion.

Restricted payments and investments: Builder baskets grow with retained excess cash flow and equity proceeds, while ratio-based carve-outs unlock when leverage falls. Keep EBITDA cures out of the math for these baskets and the available amount.
Incrementals and sidecars: Free-and-clear tranches add fixed grower capacity; ratio-based capacity stacks on top if leverage remains below a threshold. Reclassification can recycle capacity later, so cap or condition it to avoid compounding beyond the underwriting case.
Maintenance alignment: Do not set the maintenance level tighter than the incurrence ratio used to size new debt or paper capacity will trigger immediate maintenance problems.

Documentation, reporting, and accounting choices

Map ownership early. The credit agreement houses definitions, tests, levels, and cures. Lender counsel polishes caps and protections; the agent vets the compliance certificate. Security and guarantees define secured vs total debt and cash netting eligibility and tie to trapped cash and asset sale sweeps. Intercreditor or AAL provisions set enforcement priority and ensure cure rights apply consistently across tranches. For an overview of drafting priorities, see this guide to intercreditor agreements.

IFRS vs US GAAP differences – especially lease accounting – alter EBITDA and debt. Use frozen GAAP or targeted normalizations so accounting changes do not move the goalposts. Require quarterly financials with footnotes on material adjustments and a compliance certificate that reconciles to defined EBITDA. Clarify that an audit going concern paragraph, by itself, does not create a default absent a separate breach.

Economics in practice: waivers, ratchets, and amendment pricing

A maintenance miss typically leads to a waiver and amendment with fees, margin moves, tighter baskets, and added reporting. Since rates rose, lenders have used amendments to right-size add backs, tighten cash controls, and pair cures with equity support. Margin ratchets tied to leverage can conflict with EBITDA cures; carve cured EBITDA out of the ratchet grid or lenders get a price cut when risk rises.

Operational risk controls that prevent surprises

The worst covenant issues come from operational slippage, not dictionary ambiguity. Assign one owner to the covenant model, often treasury or FP&A, separate from the deal team. Keep a living bridge from GAAP to defined EBITDA with documentation for each add back. Run a monthly forecast with 5, 10, and 20% EBITDA downsides and working-capital swings. Pre-clear odd add backs with the agent and build a cure playbook – funding sources, board approvals, timing – before you need it.

One practical addition is a red-amber-green covenant calendar. Flag quarters with less than four quarters of headroom as amber and any quarter that risks a test breach as red. Sync that calendar with board meetings and M&A timing to prevent accidental tripwires.

Edge cases worth drafting up front

Trapped cash: Define readily available cash, lay out upstream mechanics, and tie to guarantees and security.
Earnouts and seller notes: Include when due and payable, not at initial fair value, to avoid leverage whipsaws.
FX swings: Test in the functional currency or lock rates for testing to reduce noise.
Business pivots: Caps on add backs and board approval for new programs prevent add backs from becoming a permanent subsidy.

Alternatives and fit: choose the right tripwire

BSL covenant lite prioritizes flexibility and market access. Private credit trades some flexibility for speed and a single decision-maker. In stress, private credit can amend quickly and trade terms for capital, while broad syndicates move slower. For add-on strategies, consider the interaction with delayed draw term loans and how those draws flow through leverage tests.

Springing leverage vs minimum liquidity is another choice. In volatile EBITDA sectors, minimum liquidity can be cleaner; leverage tests better protect against stacking new debt into a softening base. First-lien vs total leverage tests should reflect junior debt capacity. If you expect junior capacity, align definitions with US vs Europe covenant differences to avoid regional mismatches.

Implementation timeline and quick checks

Sequence matters. Settle definitions first, then numbers. Do not agree to 5.75x net leverage headlines before EBITDA and debt definitions are closed. One vague add back can move real headroom by a full turn. From term sheet to closing, finalize EBITDA add backs, lease accounting treatment, cash netting, and cure mechanics, and have the agent sign off on the certificate form. Post close, run a monthly forecast and reach out early if headroom falls below four quarters.

Undefined add backs: If three people cannot independently calculate LTM defined EBITDA within 1% using current files, the definitions are not implementable.
Step-down timing: If compliance requires base case plus 90% of synergies inside two quarters, reset levels or delay the step down.
Cure leakage: If EBITDA cures open RP or investment capacity or drop pricing, rewrite the carve outs.
RCF trigger mismatch: If seasonal revolver plans exceed the trigger more than one quarter a year, change the trigger base or pre-fund cash.
Cash netting: If over 30% of consolidated cash sits where you cannot upstream or perfect security quickly, assume zero netting in the model.
Incremental collision: Align incurrence and maintenance tests so new debt capacity does not immediately trip maintenance.

Negotiation priorities for both sides

Sponsors should push for one first-lien net leverage maintenance test with step downs that track deleveraging and avoid coverage tests unless cash dynamics are steady. Win EBITDA cures with carry-forward and caps as a percentage of LTM EBITDA, exclude cured EBITDA from leakage and pricing grids, permit cures with subordinated shareholder instruments, and lock frozen GAAP with explicit lease normalizations. Codify synergy add backs with a clear timeline and certification, set springing thresholds off real revolver usage, and align incurrence and maintenance tests. For more context on structure choices, see this guide to financial covenants and this overview of maintenance covenant norms.

Lenders should require a schedule of historical EBITDA adjustments and a GAAP-to-defined bridge, haircut unverified add backs, and size day-one headroom to absorb a multi-quarter downside without a cure and a severe case with one cure. Calibrate baskets to operating needs, constrain cure frequency and carry-forward, and demand rigorous compliance certificates with CFO certification and clear auditor comfort triggers.

When covenant lite truly fits

Covenant lite can work when liquidity is deep, free cash flow is strong and steady, revolver usage is seasonal and predictable, and sponsor support is credible. Lenders then rely on springing RCF tests and incurrence controls. It fits less well where working capital is jumpy or the thesis depends on stacking leverage for add-ons; a maintenance test protects against overreach. In acquisition-heavy programs, check how add-on debt, potential Holdco PIK notes, and any second-lien layer will interact with maintenance levels.

A compact example to stress test your setup

Consider a unitranche with a 6.00x first-lien net leverage maintenance covenant, stepping to 5.50x after four quarters. Closing leverage on defined EBITDA is 5.25x. The base case delevers to 4.75x by Q4. A 15% EBITDA miss lifts Q4 leverage to 5.59x, flirting with breach after the step down. An EBITDA cure equal to 5% of LTM EBITDA resets Q4 to 5.31x, within caps. If cured EBITDA also grew RP capacity, the borrower could open leakage while cash is tight, so carve cured EBITDA out of all leverage-driven baskets to contain risk. For a broader market view of structures like this, see this overview of unitranche loans.

Enforcement realities you can plan for

Private credit lenders can move quickly on waivers, reprice risk, add controls, and pair flexibility with sponsor capital. Broad syndicates coordinate more slowly and springing RCF covenants often become the negotiation hinge because ongoing liquidity depends on bank consent. Plan accordingly and avoid making liquidity access the only lever in a stressed quarter.

Conclusion

Covenants work when definitions are precise, levels reflect a real downside, and cures buy time without eroding discipline. Sponsors should spend energy on EBITDA definitions, cash netting, and cure mechanics and accept a single leverage maintenance test with rational step downs. Lenders should price to the true tripwire and protect leakage controls and incurrence alignment. Done right, the covenant is a seat belt: you forget it is there until you need it – and then you are glad you buckled it.