Could someone please explain the difference between them? Thanks!
Maintenance Covenants vs Incurrence Covenants
A covenant is a term used in loan documents (for example in an LBO) and any other kind of bond issuance and it dictates any terms of a corporate takeover or acquisition or bond repayment. Covenants are a critical part of credit analysis, and it's important to understand how covenants work for private equity interviews.
A maintenance covenant requires the borrower to maintain a certain level of activity. Example:
- The borrower must maintain a debt to ebitda ratio of less than 5.0x
- The ratio will be tested for compliance on a quarterly basis
- If the borrower is not in compliance, they are in default
An incurrence covenant only takes effect if the borrower is taking a specified action. Example:
- The borrower must not incur new/additional debt unless the borrower's debt to ebitda ratio is less than 5.0x after giving pro forma treatment for the new debt
- This covenant will not be tested on a regular basis and does not have to be "maintained," it will only be tested in the event that the borrower incurs new debt
- So if the borrower has this covenant and issues new bonds that bring debt to ebitda to 6.0x, the borrow is in default (in other words, they can't take this action)
- If the borrower's debt-to-ebitda ratio goes above 5.0x because EBITDA is declining and not because the borrower incurred new debt, then there is no default under this covenant