Negative Covenants
Definition
Negative covenants prohibit or limit specific borrower actions that could impair lender recovery or subordinate lender claims. Standard negative covenants include: limitations on liens (restricting additional secured debt), limitations on debt (restricting new borrowings), limitations on guarantees (restricting contingent liabilities), restrictions on fundamental changes (mergers, asset sales, business changes), and limitations on restricted payments (dividends, buybacks). Unlike financial covenants which impose quantitative thresholds, negative covenants establish qualitative restrictions on borrower behavior—enforced through permitted baskets, ratio tests, or outright prohibitions.
Why it matters
Negative covenants protect lender collateral value and claim priority by preventing borrowers from taking actions that would dilute, subordinate, or impair recoveries. Without negative covenants, borrowers could layer additional secured debt ahead of existing lenders (priming), strip and sell valuable assets, guarantee obligations of distressed affiliates, or distribute all cash as dividends before defaulting. The covenant package creates a fence around lender claims—the tighter the negative covenants, the more protected lenders are, but the less operational flexibility borrowers have. Private credit agreements typically have comprehensive negative covenants with small permitted baskets, while covenant-lite structures contain only minimal negative covenants, shifting risk to lenders in exchange for pricing premiums.
Common misconceptions
- •Negative covenants aren't absolute prohibitions—they're structured as 'shall not, except' with carved-out permitted actions. The covenant negotiation centers on carve-out size and conditions.
- •Violating negative covenants creates immediate events of default (no cure period), unlike financial covenant breaches which typically allow 30-day equity cures. This makes negative covenant violations more serious.
- •Modern covenant packages include extensive 'incremental facilities' allowing borrowers to incur additional debt meeting certain tests. The label 'restrictions on debt' is misleading—material flexibility often exists within the restrictions.
Technical details
Limitations on liens
Core restriction: Borrowers shall not create, incur, or permit to exist any lien on any property or asset, except for permitted liens. This prevents borrowers from granting security interests to new lenders that would dilute or prime existing secured lenders.
Permitted liens carve-outs: (i) Liens securing existing credit agreement (subject to intercreditor), (ii) Purchase money security interests for equipment (up to $10M annually), (iii) Statutory liens (tax liens, mechanics liens) arising in ordinary course, (iv) Liens securing permitted debt (ratio debt, incremental facilities), (v) Liens on acquired company assets (existing at acquisition, not incurred in contemplation).
Incremental secured debt capacity: Modern credit agreements allow 'incremental term loans' up to greater of (a) $X fixed amount or (b) ratio-based capacity (1.0x EBITDA). These rank pari passu with existing first lien debt, effectively allowing borrowers to double leverage if meeting ratio tests. Incrementals represented 25% of middle-market financings by 2023.
Anti-circumvention provisions: Negative pledge on equity interests in subsidiaries prevents borrowers from granting liens on subsidiary stock (which effectively subordinates parent-level lenders). Sale-leaseback restrictions prevent borrowers from selling assets and leasing them back (avoiding asset sale proceeds mandatory prepayment).
Limitations on debt
Core restriction: Borrowers shall not create, incur, assume, or guarantee any debt, except for permitted debt. Prevents unlimited borrowing that would increase claims ahead of existing lenders.
Permitted debt carve-outs: (i) Debt under existing credit agreement, (ii) General basket ($25-50M), (iii) Ratio debt (unlimited if leverage ≤ 6.5x), (iv) Acquired debt (existing at acquisition up to $X), (v) Intercompany debt, (vi) Capital lease obligations ($10-15M annually), (vii) Incremental facilities (greater of $X or Y× EBITDA).
Ratio debt concept: If maintaining specified leverage ratio (typically 6.5x, 0.5x looser than maintenance covenant), can incur unlimited additional debt. Creates two-tier system—strong performers access unlimited capital; weak performers restricted to baskets. By 2024, 40% of new middle-market originations include ratio debt provisions.
Junior debt restrictions: Can incur subordinated debt up to $X or meeting ratio test if (a) matures after existing debt, (b) subordinated per intercreditor agreement, (c) no cash interest if leverage >6.0x, (d) no events of default except payment and bankruptcy. These provisions protect senior recovery by keeping junior debt truly subordinated.
Restricted payments and dividend restrictions
Core restriction: Borrowers shall not declare or pay dividends, distributions, or repurchase equity, except for permitted restricted payments. Prevents borrowers from stripping cash while lenders hold bag in subsequent default.
Permitted restricted payments: (i) General basket ($10-25M), (ii) Builder basket (50% of cumulative net income since closing), (iii) Proceeds basket (100% of equity issuance proceeds), (iv) Ratio-based payments (if FCCR ≥ 2.0x and no defaults). Builder basket rewards profitable companies with distribution capacity; FCCR test ensures ongoing coverage capacity.
Management and board fees: Typically permitted up to $5-10M annually for PE-owned companies despite being economically distributions. Lenders accept as cost of sponsor ownership but cap to prevent abuse. Subject to no default existing condition.
Tax distributions for pass-through entities: S-Corps and LLCs taxed as partnerships can make distributions sufficient to cover owners' tax liabilities on allocable income (typically 40% of taxable income). Without this carve-out, owners personally liable for taxes on income they can't access—impractical structure.
Fundamental change restrictions
Limitation on asset sales: Cannot sell, transfer, or dispose of assets exceeding $X annually (typically $10-25M) unless (i) fair value received, (ii) 75% of proceeds used to prepay debt or reinvest in similar assets within 12 months, (iii) assets sold are obsolete, worn-out, or no longer used in business. Prevents value-destructive asset stripping.
Merger and consolidation restrictions: Cannot merge, consolidate, or fundamentally change business unless (i) borrower is surviving entity OR (ii) surviving entity assumes all obligations, provides guarantees/collateral, and maintains pro forma covenant compliance. Protects against borrower merging into distressed entity or changing business to unsecured cash services company.
Lines of business restrictions: Must conduct same business as on closing date or reasonably related businesses. Prevents borrower pivoting from manufacturing (asset-heavy, secured lender recovery) to consulting (asset-light, no secured lender recovery)—classic attempt to transfer value from lenders to equity.
Affiliate transaction restrictions: Transactions with affiliates must be on arms-length terms or approved by board. Prevents sponsor extracting value through management fees, unfavorable supply contracts, or asset transfers to related entities. Board approval requirement creates check on self-dealing.