Incurrence Covenants
Definition
Incurrence covenants restrict specific borrower actions and are tested only when those actions are proposed—not on an ongoing basis. Common incurrence tests include: debt incurrence (can issue new debt if pro forma leverage ≤ 6.5x), restricted payments (can pay dividends if FCCR ≥ 2.0x), investments/acquisitions (limited by basket sizes or ratio tests), and asset sales (must use proceeds to prepay debt or reinvest). Unlike maintenance covenants which trigger based solely on financial deterioration, incurrence covenants only become relevant when borrowers attempt restricted transactions.
Why it matters
Incurrence covenants shift control timing from performance-based triggers to transaction-based gates. A borrower at 7.0x leverage violates maintenance covenants (typically 6.0x limit) automatically, triggering defaults and lender negotiations. That same borrower under incurrence-only structure remains compliant unless attempting to incur new debt, pay dividends, or make acquisitions—at which point ratio tests block the transaction but don't trigger defaults. This distinction explains why covenant-lite structures (incurrence-only) have 10-15 point lower recovery rates than maintenance covenant loans—lenders lose the early warning system and only gain control at payment default when enterprise value has typically eroded below debt levels.
Common misconceptions
- •Incurrence covenants aren't optional—they're binding restrictions that must be satisfied before completing restricted transactions. The difference is testing timing, not enforceability.
- •Violating incurrence tests doesn't create defaults—it simply prohibits the proposed transaction. Companies remain compliant as long as they don't attempt restricted actions.
- •Incurrence-only structures aren't completely covenant-free. Most include negative covenants (limitations on liens, guarantees, asset sales) and affirmative covenants (financial reporting, insurance maintenance) that provide some lender protections.
Technical details
Standard incurrence test structures
Debt incurrence test: Borrower can issue additional debt if pro forma Total Leverage ≤ 6.5x AND pro forma FCCR ≥ 1.5x, calculated giving effect to new debt. 'Pro forma' includes projected EBITDA from debt-funded acquisitions, synergies (capped at 50% of projections), and other adjustments. Test typically more lenient than maintenance covenants (6.5x incurrence vs 6.0x maintenance).
Restricted payments test: Dividends, distributions, and share buybacks permitted if (i) pro forma FCCR ≥ 2.0x, (ii) no defaults existing or resulting, and (iii) cumulative restricted payments don't exceed available basket. 'Available basket' typically starts at $10-25M plus 50% of cumulative net income since closing.
Investment and acquisition test: Can make investments/acquisitions if pro forma leverage ≤ 6.0x. Alternatively, can use 'general basket' ($25-50M) or 'net proceeds basket' (75% of equity issuance proceeds) without ratio test. Multiple pathways allow sophisticated borrowers to structure around restrictions.
Asset sale covenant: Must use 75% of net proceeds to prepay debt OR reinvest in similar assets within 12-18 months. 'Net proceeds' = gross proceeds minus taxes, costs, working capital adjustments. Creates tension—borrowers want to redeploy capital, lenders want deleveraging.
Basket mechanics and builder baskets
Fixed dollar baskets: Most incurrence covenants include fixed baskets allowing transactions without ratio tests. Examples: $25M general investment basket, $50M restricted payment basket, $10M junior debt basket. Baskets provide flexibility for small transactions while preserving ratio tests for larger deals.
Grower baskets: Baskets that increase based on performance metrics. Common structure: 'Greater of (i) $25M or (ii) 25% of Consolidated EBITDA.' High-performing borrowers gain more flexibility; struggling borrowers face tighter restrictions. Aligns incentives.
Builder baskets: Accumulate over time based on retained earnings or debt paydown. Example: 'Restricted payment basket = $10M + 50% of cumulative net income + 100% of equity issuance proceeds.' Companies that generate cash and retain earnings earn capacity for future distributions.
Ratio debt basket: Can incur unlimited debt if maintaining investment-grade leverage (typically <3.5x). Creates two-tier structure—ratio-based capacity for strong credits, basket-based limits for weaker credits. Sophisticated borrowers optimize capital structure to access ratio debt.
Pro forma calculation mechanics
Pro forma EBITDA adjustments: When testing incurrence covenants, borrowers can adjust EBITDA for: (i) full-period EBITDA of acquired businesses (even if owned <1 quarter), (ii) projected cost synergies (typically 50-75% of projections capped at 18 months), (iii) elimination of divested business EBITDA, and (iv) run-rate impact of completed initiatives.
Pro forma debt adjustments: New debt being incurred is added to numerator. Debt being refinanced is removed (preventing double-counting). Revolvers typically assumed at 35-50% drawn (not zero or 100%). Cash proceeds from equity issuance reduce net debt.
Example calculation: Company has $100M debt, $20M EBITDA (5.0x leverage). Proposes $40M acquisition generating $6M EBITDA with $2M cost synergies. Pro forma: ($100M existing + $40M new debt) / ($20M + $6M acquired + $2M×75% synergies) = $140M / $27.5M = 5.09x. Passes 6.5x incurrence test.
Gaming the calculations: Sophisticated borrowers use aggressive EBITDA add-backs (100% synergy realization, optimistic projections, questionable adjustments) to manufacture covenant compliance. Lenders push back on quality of earnings but have limited recourse if calculations follow credit agreement definitions.
Market evolution and structuring considerations
Shift from maintenance to incurrence: Pre-2012: 15% of institutional loans were cov-lite (incurrence-only). 2012-2019: Cov-lite grew to 75% of new issuance. 2020-2024: 80-85% of leveraged loans are incurrence-only. Private credit maintained maintenance covenants longer but now 40-50% of middle-market unitranche is incurrence-only.
Springing maintenance covenants: Hybrid structure common in institutional loans. Maintenance covenants only 'spring' into effect when revolver utilization exceeds 35-40%. Provides lender protection when liquidity strained (high revolver use signals stress) while avoiding maintenance tests during normal operations.
Incurrence covenant tightness varies: Aggressive cov-lite: 7.0x+ debt incurrence test, minimal restricted payment restrictions, large baskets. Conservative cov-lite: 6.0x debt incurrence test, 2.5x FCCR for dividends, small baskets. The label 'covenant-lite' encompasses wide range of actual restrictions.
Negotiating dynamics: Borrowers want maximum flexibility—loose ratio tests, large baskets, minimal restrictions. Lenders want tighter controls—lower ratio thresholds, smaller baskets, catch-all provisions preventing circumvention. In competitive markets, borrower-friendly terms prevail. In stressed environments, lenders extract tighter covenants.