Covenant Breaches
Definition
Covenant breaches occur when borrowers violate financial covenants (leverage ratio exceeds 6.0x limit), negative covenants (incur prohibited debt, create unauthorized liens), or affirmative covenants (fail to deliver financial statements, maintain insurance). Breaches create Events of Default under credit agreements, giving lenders rights to accelerate debt, cease funding, demand immediate repayment, or foreclose on collateral. However, most breaches are cured through amendments—borrowers negotiate waivers or covenant relief in exchange for fees (25-100 bps), spread increases (50-100 bps), and tighter terms. The breach-amendment cycle is core to private credit economics, generating significant fee income while avoiding value-destructive enforcement.
Why it matters
Covenant breaches are inflection points where power shifts from borrowers to lenders—temporarily. During 2020, 30-40% of middle-market credits breached covenants as EBITDA collapsed, triggering massive amendment wave. Lenders extracted $500M+ in amendment fees, spread increases of 50-200 bps, and enhanced reporting/control rights. But lender behavior varied dramatically: sophisticated lenders negotiated 'partnership amendments' preserving relationships; aggressive lenders demanded punitive terms destroying sponsor relationships; weak lenders granted free waivers fearing default recognition. Understanding breach dynamics—when to amend vs enforce, how to price relief, what terms to demand—determines whether lenders generate returns through fees or suffer losses through defaults.
Common misconceptions
- •Covenant breaches don't automatically default loans—they create Events of Default giving lenders enforcement rights. Lenders must affirmatively exercise rights; defaults don't self-execute.
- •Most breaches are cured, not enforced. 80%+ of covenant violations result in amendments, not acceleration. Enforcement is last resort when amendment negotiations fail or fraud discovered.
- •Equity cure rights don't eliminate breaches—they allow sponsor capital injections that retroactively satisfy covenant calculations, curing defaults before becoming effective.
Technical details
Types of covenant breaches and severity ranking
Financial covenant breaches: Leverage exceeds maximum (6.2x vs 6.0x limit), interest coverage falls below minimum (2.3x vs 2.5x requirement), liquidity drops below floor ($8M vs $10M minimum), EBITDA falls below absolute floor ($18M vs $20M covenant). Severity depends on magnitude and trend—small breach with improving trajectory less severe than deteriorating compliance.
Negative covenant breaches: Unauthorized debt issuance (violates debt incurrence test), unauthorized liens (grants security without lender consent), prohibited asset sales (sells subsidiary without approval), excess restricted payments (dividends violating payment test). Material breaches that subordinate lender claims or strip assets are most severe.
Affirmative covenant breaches: Late financial statement delivery (financial covenants—45 days past deadline), failure to maintain insurance (property damage risk), failure to pay taxes (creates senior tax liens), unauthorized business changes (enters new line of business). Generally less severe but signals management dysfunction or intentional non-compliance.
Cross-default provisions: Defaults under other debt agreements trigger default under current agreement even if current loan compliant. Example: Borrower defaults on subordinated notes; senior loan cross-default clause makes it Event of Default under senior facility too. Creates cascade where single breach triggers multi-facility defaults.
Cure periods and equity cure mechanics
Standard cure periods: Financial covenant breaches typically allow 30-day cure period (time to inject equity or cure via asset sale). Payment defaults have no cure period (immediate Event of Default). Affirmative covenant breaches allow 5-10 business days (administrative fix time). Negative covenant breaches generally no cure period (intentional prohibited action).
Equity cure mechanics: Sponsor injects cash equity which counts as EBITDA for covenant calculation purposes. Example: Company at 6.3x leverage (breaches 6.0x), sponsor injects $10M equity which adds to EBITDA calculation, bringing leverage to 5.8x (compliant). Equity must be subordinated to debt, used to prepay debt or held as restricted cash.
Equity cure limitations: Most agreements limit to 2-3 equity cures in 12-month period and 5 cures over loan life. Prevents serial equity injections masking fundamental deterioration. Some agreements prohibit equity cures if leverage exceeds threshold (e.g., can't cure if leverage >7.0x—too far gone). Cure equity cannot exceed 25% of required EBITDA (anti-gaming provision).
Net worth build cure: Alternative to cash equity—sponsor contributes assets (equipment, IP, subsidiary stock) valued by third-party appraiser. Asset value added to equity calculation curing net worth covenant breaches. More common in asset-heavy businesses where sponsor holds unencumbered assets.
Amendment negotiation dynamics and pricing
Amendment fee structure: Borrowers pay 25-100 bps of outstanding commitments for covenant relief. Standard: 50 bps for minor relief (leverage 6.0x to 6.5x for 2 quarters), 75-100 bps for material relief (eliminate covenants, extend cure periods). Fees paid upfront regardless of whether borrower ultimately draws facility—compensates lenders for assumed risk increase.
Spread increases: Lenders demand 50-100 bps spread increases on top of amendment fees. Example: Loan at L+450 breaches covenants, amendment increases to L+525. Permanent pricing adjustment reflecting higher risk profile. In stressed situations (2020), spread increases reached 100-200 bps as lenders extracted maximum value during negotiations.
Enhanced terms: Beyond fees and spread, lenders extract: (i) Financial reporting frequency (monthly vs quarterly), (ii) Minimum liquidity increases, (iii) Restrictions on new investments, (iv) Required asset sales or equity raises, (v) Board observer rights. These non-pricing terms often more valuable than fees—provide early warning system for future issues.
Negotiating leverage: Borrowers have leverage if (a) breach temporary and curable (inventory buildup causes one-quarter leverage spike), (b) sponsor has strong relationship and credible cure plan, (c) alternative financing available (can threaten refinancing). Lenders have leverage if (d) material deterioration obvious, (e) no alternative financing available (market shut for this credit), (f) cross-defaults create multi-lender enforcement threat.
Breach resolution outcomes and lender strategies
Amendment and waiver (80% of cases): Lenders grant covenant relief temporarily (2-4 quarters) or permanently (covenant elimination). Borrower pays fees, accepts spread increase, provides enhanced reporting. Structure continues without disruption. Lender earns fee income, preserves performing loan status, maintains relationship for future business.
Standstill and forbearance (15% of cases): Lenders agree not to enforce default for 30-90 days while parties negotiate comprehensive amendment or refinancing. Used when breach material but workout possible. Standstill agreement includes: waiver of acceleration rights during period, enhanced reporting requirements, forbearance fee, agreement on amendment principles. Buys time for complex restructurings.
Enforcement and acceleration (5% of cases): Lenders accelerate debt, pursue foreclosure or legal action. Reserved for: (i) Fraud or material misrepresentation, (ii) Asset stripping or insider dealing, (iii) Borrower refusing to negotiate or proposing unrealistic amendments, (iv) Multiple serial breaches suggesting terminal decline. Enforcement often converts to bankruptcy—lenders become DIP lenders or participate in restructuring.
Lender internal dynamics: Multi-lender facilities require 50-67% consent for amendments. Sophisticated lenders balance fee income against default recognition—prefer amendments preserving asset quality. Some lenders vote against amendments hoping to force default and liquidity event. Unitranche lenders have unified interest; syndicated loans face holdout dynamics where minority lenders extract disproportionate concessions.