Maintenance Covenants
Definition
Maintenance covenants are financial tests that borrowers must satisfy on a recurring basis—typically quarterly—regardless of whether they take any specific actions. Common examples include maximum leverage ratios (Total Debt / EBITDA ≤ 6.0x), minimum interest coverage (EBITDA / Interest ≥ 2.5x), and minimum liquidity requirements. Unlike incurrence covenants which only trigger when borrowers attempt restricted activities, maintenance covenants create ongoing compliance obligations tied directly to financial performance.
Why it matters
Maintenance covenants serve as early warning systems for lenders, triggering defaults 12-18 months before payment failures when companies can still be restructured. This timing advantage is critical—when a company breaches leverage covenants at 6.5x (violating 6.0x limit), enterprise value typically remains above debt levels, giving lenders negotiating leverage to extract fees, demand equity cures, or influence management changes. Without maintenance covenants, lenders only gain control at payment default when the company hits 8-10x leverage and recovery values have eroded significantly. The shift toward covenant-lite structures (eliminating maintenance tests) fundamentally transferred this early warning advantage from lenders to borrowers, reducing recovery rates by 10-15 percentage points in distressed scenarios.
Common misconceptions
- •Maintenance covenants aren't tested on transaction dates—they're measured quarterly based on trailing financial results regardless of borrower activity.
- •Passing maintenance covenants doesn't prevent deterioration. Companies can remain compliant while underlying business weakens through aggressive EBITDA add-backs, asset sales, or equity infusions.
- •Breaching maintenance covenants doesn't immediately accelerate debt. Most credit agreements provide cure periods (30 days for equity cure, 5-10 days for calculation errors) before defaults become effective.
Technical details
Standard maintenance covenant structures
Total Leverage Ratio: Total Debt / EBITDA ≤ 6.0x. Most common financial covenant in middle-market credit agreements. 'Total Debt' includes revolver drawings, term loans, subordinated debt, capital leases, and off-balance-sheet financing. 'EBITDA' uses trailing twelve-month (TTM) results with permitted add-backs (typically 15-25% of reported EBITDA).
Senior Leverage Ratio: Senior Debt / EBITDA ≤ 4.5x. Used in multi-tranche structures to protect senior lenders. Excludes subordinated debt from numerator. Often 1.0-1.5x tighter than total leverage covenant.
Interest Coverage Ratio: EBITDA / Cash Interest Expense ≥ 2.5x. Protects against interest payment stress. 'Cash Interest' excludes PIK interest and OID amortization. Covenant typically sets minimum at 2.0-3.0x depending on business volatility.
Fixed Charge Coverage Ratio (FCCR): (EBITDA - Capex) / (Interest + Scheduled Principal + Dividends) ≥ 1.1x. Most restrictive covenant—tests ability to service all fixed obligations including debt amortization. 'Capex' often uses maintenance capex only (excludes growth capex).
Testing mechanics and compliance certificates
Testing frequency: Covenants measured on last day of each fiscal quarter (March 31, June 30, September 30, December 31). Some agreements test monthly for high-risk credits.
Compliance certificate delivery: Borrowers must deliver compliance certificates within 45 days of quarter-end (public companies) or 60 days (private companies). Certificate includes covenant calculations, representations regarding defaults, and officer certification.
Cure period mechanics: Equity cure rights typically allow 15-30 days after compliance certificate due date to inject equity capital. Equity must be subordinated to debt, used to repay debt or held as restricted cash, and counts as EBITDA for covenant calculation. Most agreements limit cures to 2-3 times in rolling 12-month period.
Step-down provisions: Leverage covenants often step down over time (6.5x Year 1, 6.0x Year 2, 5.5x Year 3+) reflecting expected deleveraging. Coverage covenants may step up (2.0x Year 1, 2.25x Year 2, 2.5x Year 3+).
EBITDA adjustments and add-back limitations
Permitted add-backs include: Non-cash charges (depreciation, amortization, stock compensation), restructuring charges (capped at 15-20% of EBITDA), non-recurring items (litigation settlements, one-time costs), pro forma cost savings from acquisitions (typically 50-75% of projected synergies capped at 12-18 months).
Quality of earnings considerations: Aggressive add-backs inflate EBITDA and create artificial covenant headroom. During 2020-2021, many PE-backed companies added back 'COVID-related losses' representing 30-40% of reported EBITDA—masking true leverage. Sophisticated lenders scrutinize add-back quality and limit cumulative adjustments.
Pro forma EBITDA for acquisitions: Companies can include acquired EBITDA for full trailing period despite ownership for partial quarter. Combined with synergy add-backs, this can materially overstate actual earnings power. Lenders typically cap pro forma adjustments at 25-35% of total EBITDA.
Breach consequences and negotiation dynamics
Immediate consequences of breach: Automatic event of default upon covenant violation (subject to cure period). Lenders gain right to accelerate debt, cease funding revolvers, and foreclose on collateral. However, most lenders pursue amendment rather than acceleration.
Amendment negotiations: Borrowers typically seek covenant relief through amendments. Amendment fees range from 25-100 bps of outstanding debt. Lenders may demand: pricing increases (50-100 bps spread increase), tighter terms (stricter baskets, additional reporting), collateral enhancements, or board representation.
Equity cure dynamics: Sponsors inject equity to avoid default and preserve control. However, equity cures are expensive—$10M equity injection to cure leverage covenant on $150M debt effectively costs sponsors $10M to avoid default that might occur anyway months later. Sophisticated sponsors evaluate cure economics vs controlled default scenarios.
Covenant reset negotiations: During 2020, 40% of middle-market credits amended covenants. Typical amendments: 0.5-1.0x leverage relief for 2-4 quarters, extended amortization, increased add-back baskets. Lenders extracted 50-200 bps spread increases plus 50-100 bps amendment fees.