Covenant-lite loans remove ongoing quarterly maintenance tests and rely on incurrence covenants that restrict actions such as extra debt, dividends, or asset sales unless ratios are met at the moment the borrower takes that action. In Europe’s mid-market private credit, a common variant is the springing leverage covenant that turns on only when the revolving credit facility is drawn above a set threshold. When usage stays below that line, the deal behaves like covenant-lite. The payoff for sponsors is faster execution and fewer amendments. The trade-off for lenders is weaker early warning and a shorter runway if liquidity tightens.
Covenant-loose deals are different because they still include a maintenance test, but they dilute it with generous EBITDA add-backs, equity cures, and wide headroom. The practical divider for operators is simple. If a quarterly test does not constrain behavior while there is still liquidity, then for long stretches you are functionally covenant-lite.
Where the European market sits now and why it matters
Mid-market in this context means sponsor-backed borrowers with about €20 million to €150 million of EBITDA, with the shift most visible in the upper mid-market and clubbed unitranche deals that can toggle between direct lending and the syndicated loan market. That choice sets terms and documentation leverage. In European broadly syndicated loans, covenant-lite penetration has sat above 90 percent for years and remained elevated in the first half of 2024, according to market trackers. Sponsors have brought that playbook to private credit as competition sharpened and as lenders prioritized mandate wins and refinancings over strict covenants.
Dry powder supports flexibility. Private debt assets under management and undeployed capital remain large, so funds need deployment and certainty. Flexible covenants cut execution friction and help close on time. When base rates are high, the all-in pricing gap between direct lending and syndicated loans narrows while settlement frictions in syndicated markets slow time to cash, which lets direct lenders compete on documentation rather than price. Dual-track runs are now routine, with a unitranche in one lane and a covenant-lite Term Loan B in the other. Direct lenders often concede on maintenance tests and portability to avoid being edged out.
Club dynamics also favor covenant-lite. Two to five lender clubs are common, typically alongside a super senior revolving facility. Clubs are harder to steer through repeated covenant resets in choppy conditions, and incurrence-style documentation reduces waiver churn and committee wrangling. Sponsors argue committee fights do not add value. Many lenders accept lighter maintenance in exchange for tighter baskets and better information and access rights.
Documentation terms have converged across the Atlantic as US sponsors expect European private credit to mirror US norms. English law agreements now frequently include US-style builder and grower baskets, portability regimes, and broader restricted payments capacity. Supervisors have taken note. Reviews by European authorities in 2024 flagged persistently weak covenants and uncertainty about private credit through a full cycle. They are not dictating terms, but deal teams feel the scrutiny.
How covenant-lite structures actually work in practice
A typical structure uses a Luxembourg or Dutch holdco, an English law facility agreement, and whole-of-business security through share pledges and local-law security documents. Banks provide a super senior revolving credit facility on LMA-style terms with a springing leverage covenant for the RCF’s benefit. The core term loan is most often a unitranche loan that shares security on a second-ranking basis under an intercreditor deed, which results in structural subordination to the RCF when the springing test is active.
While the RCF is undrawn or below a negotiated threshold, often 35 to 40 percent of commitments, no maintenance test applies. Cross that line and a senior secured net leverage test springs on. The unitranche usually benefits from that test when active, but the test lies dormant at low RCF usage. Borrowers can manage timing of cash and RCF draws to avoid breaching a springing test, which introduces behavioral risk if liquidity buffers are thin.
In the absence of a live maintenance test, the incurrence covenant suite carries most of the load. Borrowers can add debt if leverage satisfies a ratio at incurrence and stays within fixed baskets, including ratio debt. Dividends sit on a builder basket that grows with the available amount, often tied to retained excess cash flow. Investments rely on dollar or grower baskets and ratio permissions. Most-favored-nation protections on incremental debt sometimes sunset or carve out room for priming or sidecars after a period, which can leave room for later-layer priming if not locked down.
EBITDA definitions become the fulcrum. Add-backs for run-rate synergies, cost saves, and revenue uplift can be broad, sometimes capped but with long realization periods. Equity cures can apply to EBITDA, not just to debt, which changes the math of breaches. A maintenance test linked to elastic EBITDA behaves more like an incurrence covenant. Count the add-backs; they matter more than the raw covenant count. For a broader overview of covenant mechanics, see this guide to financial covenants.
Documentation, control points, and intercreditor realities
English law typically governs the facility agreement and the intercreditor deed even when assets sit in France, Germany, Italy, or Spain. Security is taken in local law form for perfection. The intercreditor deed sets the waterfall, voting thresholds, enforcement steps, and standstill periods. Side letters cover MFN carve-outs, the life of certain protections, and consent packages for add-ons. Representations and warranties live in the facility agreement with deliverables and completeness certificates at closing. For the priority rules that govern recoveries, review the basics of intercreditor agreements.
Consent rights concentrate within the lending club. Sacred rights cover principal, margin, maturity, and release of substantially all security. Transfer restrictions are tighter in covenant-lite deals to keep relationship lenders in the syndicate. White lists and minimum hold levels require sponsor consent to transfer, which can slow turnover in stress and reduce flexibility to reconstitute a more assertive lender group.
Economics reflect the trade lenders are making
If lenders concede on maintenance tests, they push on price and protections. Call protection is thick, with 102 to 101 hard call in year one and two, and sometimes soft-call prepayment fees on refinancings. Original issue discount and upfront fees vary with credit quality. Margin ratchets still appear, but step-downs are less generous when covenants are light. RCF commitment and utilization fees compensate banks for carrying the only live maintenance test when sprung.
Pricing remains situational. Upper mid-market sponsor credits cleared at double-digit all-in yields through 2023 and 2024 due to higher base rates, then saw margin compression as competition intensified. Where sponsors can credibly run a dual track, direct lenders often trade maintenance tests for anchor allocations rather than widen spreads further. For context on demand drivers across strategies, see the broader private credit market outlook.
Credit implications: what changes when early warning is weaker
Without a maintenance covenant, the first default is more likely to be a payment default, an insolvency event, or a springing breach of the RCF during a liquidity squeeze. That compresses the time to restructure and shifts emphasis to sponsor engagement and to blocking value leakage through restricted payment and investment limits. When the early whistle is gone, field position matters more.
Restructuring regimes shape outcomes. English share pledge enforcement remains efficient and typically out of court. Cross-border groups face civil-law friction. Germany’s StaRUG, France’s sauvegarde and conciliation, and Italy’s composition tools enable debtor-led processes. Without a live maintenance default, lenders often rely on forbearance agreements and plan negotiations rather than formal default triggers. That puts a premium on information rights and board access.
Fresh angle: a practical early-warning dashboard
In covenant-lite portfolios, disciplined monitoring can substitute for absent tests. Lenders can adopt a simple dashboard focused on three signals that tend to deteriorate first.
- Liquidity cadence: Track 13-week cash flows against forecast with a rolling variance cap and a minimum number of weeks of runway at current burn.
- Order health: Measure booked orders minus cancellations and price realization versus plan, not just revenue, to capture demand and pricing power early.
- RCF draw discipline: Monitor undrawn availability and intra-month peaks to spot threshold gaming before the springing test goes live.
Why lenders accept covenant-lite terms now
Defaults in sponsor-backed private credit have stayed manageable, and recoveries for the current vintage remain largely untested. Elevated base rates pad returns, so lenders can accept documentation risk when they underwrite conservatively on cash conversion and downside cases. Sponsors continue to support portfolio companies with incremental equity or preferreds, often negotiated directly with their lenders. The combination of sponsor behavior, competition for mandates, and the ability to trade documentation for allocations explains the drift toward covenant-lite.
Underwriting focus: move from ratios to structure and liquidity
In covenant-lite deals, the real protection comes from how tightly the incurrence framework and the priority stack are drafted. The following levers consistently improve outcomes.
- Tighten incurrence: Cap ratio debt and investments into non-guarantors, clarify builder basket mechanics with starters and absolute caps, and extend MFN sunsets while cutting carve-outs.
- Reduce EBITDA elasticity: Cap add-backs, narrow cost saves and synergies, and use short realization periods. If equity cures are permitted, apply them to debt rather than EBITDA or limit frequency. For background on cure mechanics, see this plain-English explainer on equity cure provisions.
- Strengthen the springing test: Lower RCF thresholds to activate, test monthly when sprung, and confirm the term lender benefits alongside the RCF. Monitor undrawn availability mechanics to prevent manipulation.
- Enhance information rights: Require monthly liquidity reporting, 13-week cash flows, and KPIs tied to orders and pricing. Seek compliance certificates even when the maintenance test is idle and obtain board observer rights where feasible.
- Control priming: Cap super senior and ABL capacity, define permitted receivables securitizations tightly, require intercreditor recognition of sidecars, and block non pro rata uptiers without all-lender consent.
- Keep portability conditional: If portability is agreed, set strict leverage and no-default conditions, a minimum equity infusion, and change-of-control fees to compensate for risk transfer.
- Police transfers: Use transfer restrictions to prevent an unfriendly bloc while allowing removal of failing participants. White lists should not shield priming strategies.
Implementation and timing: what changes in the drafting
Covenant-lite does not change the critical path of diligence, documentation, and security perfection across jurisdictions. What changes is where the drafting energy goes. Incurrence baskets, definitions, and the intercreditor tie-ins carry more substance and take longer to negotiate. Coordination across facility, intercreditor, security, and the RCF is essential so the springing mechanics work in real-world liquidity swings. For a step-by-step view of how sponsors assemble these capital stacks, compare approaches in unitranche structuring and the limits of security packages and guarantees.
Where covenant-lite fits and where it does not
Maintenance covenants remain valuable for cyclical businesses with volatile working capital and thin liquidity, and where sponsors have limited equity capacity or short hold periods. Covenant-lite can be acceptable for resilient, diversified businesses with strong pricing power, demonstrated sponsor support, and a legal structure that blocks leakage. The key is to price, structure, and monitor to the actual risk moving through baskets and priority.
Fast kill tests for covenant-lite in the European mid-market
- High customer concentration: Concentration above agreed limits without strong contractual protections.
- Negative cash generation: Negative free cash flow after maintenance capex in the base case.
- Working capital volatility: Large swings with weak visibility into cash conversion.
- FX mismatch: Large non-EU revenues with currency mismatch and no hedging policy.
- No sponsor backstop: Sponsor unwilling to commit incremental capital or grant reporting access.
- Structural leakage risk: Complex groups with large non-guarantor pools or foreign subs that cannot grant effective security.
Passing these tests makes covenant-lite workable if other protections are tight. Failing any should push the discussion back to a real maintenance covenant, lower starting leverage, or a different instrument such as a second lien loan.
What could change the trend
Three developments could slow or reverse the shift. First, a sustained rise in defaults that reveals weaker-than-modeled recoveries would prompt a documentation rethink and more robust early-warning mechanisms. Second, a deeper reopening of syndicated loan markets that narrows pricing while restoring tighter incurrence regimes would reduce sponsor leverage in direct lending. Third, supervisory pressure that raises transparency standards and emphasizes early-warning metrics for private credit funds could reset investor expectations.
Likely path through 2025
Expect a hybrid market. Upper mid-market sponsor deals will stay covenant-lite or springing-only. Lower mid-market lenders will keep a maintenance test but dilute it with EBITDA flexibility. The focus will shift to details that matter at enforcement, including baskets, portability, MFN, and priming defenses. If lenders underwrite to liquidity, leakage, and enforcement practicalities, they can avoid the worst outcomes even without a quarterly test. For a deeper definition and risk overview, compare this primer on covenant-lite loans.
Key Takeaway
Covenant-lite is a documentation choice that reallocates risk rather than eliminating it. It can be priced, structured around, and monitored. The winning approach is to know exactly which protections remain, how they operate under European law, and how they behave when liquidity tightens and sponsor support becomes selective. That is where returns are made or protected.