Loan covenants in private credit

What is a loan covenant?

A loan covenant is a set of promises or conditions included in a loan agreement that a borrower must follow. These agreements, often formally outlined in a credit agreement or loan contract, are made between a borrower and a lender to establish the rules of the loan. Think of them as the fundamental terms of engagement for any debt financing arrangement, defining the relationship and expectations for both parties.

Covenants are designed to protect the lender. By outlining specific requirements and restrictions, they help ensure the borrower maintains a certain level of financial health. This reduces the risk that the borrower will be unable to repay the loan, providing a framework for trust and accountability throughout the loan's term.

These promises create a clear set of ground rules and give the lender visibility into the borrower's business operations and financial performance. This transparency helps the lender to feel secure in their investment and the borrower to understand what is expected of them.

Why loan covenants are important in private credit

Loan covenants are especially important in the world of private credit financing, where deals traditionally offer enhanced covenants and greater downside protection for lenders compared to most broadly syndicated loans. Unlike private equity (PE) or venture capital (VC) investors who seek high returns through a company's growth, the primary goal of private credit investing is different.

Covenants provide an early warning system, and this periodic monitoring of borrowers is a key reason for historically low default rates in the asset class, as it allows capital providers to identify potential issues and step in before a problem escalates. 

This focus on risk management makes covenants the bedrock of a private credit strategy. They allow lenders to maintain control and oversight without taking an active role in the day-to-day management of the borrower's business. Essentially, covenants help lenders manage their investment from a distance while still having the mechanisms to protect their capital if the borrower's financial situation deteriorates and the loan becomes distressed debt.

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What are the types of loan covenants?

To understand how they function, it’s helpful to break loan covenants down into three main categories: affirmative covenants, negative covenants, and financial covenants. Understanding these types of covenants is important for any fund manager or company executive involved in a lending relationship, as each type has a distinct purpose in the loan agreement.

Affirmative covenants

Affirmative covenants, sometimes called positive covenants, are clauses that require the borrower to perform specific actions throughout the life of the loan. You can think of these as the must-do list that helps maintain the company's operational and financial stability. These covenants ensure that the borrower continues to operate in a responsible and transparent manner, giving the lender confidence that the business is being well-managed.

Common examples of affirmative covenants include requirements to:

• Provide timely, accurate, and audited financial statements from the general ledger (GL), such as the balance sheet and accounts receivable reports, to the lender on a regular basis

• Maintain adequate business insurance to protect against unforeseen losses

• Pay all taxes and remain in good legal standing with regulatory bodies

• Keep business properties and essential assets in good working condition

Negative covenants

Negative covenants, also known as restrictive covenants, are clauses that prohibit the borrower from taking certain actions without getting the lender's prior consent. This is the don’t-do list, designed to prevent decisions that could increase the lender's risk or negatively impact the borrower's ability to repay the loan. These restrictions are not meant to stifle the business, but rather to prevent actions that could fundamentally alter its risk profile.

These restrictions often include limitations on:

• Taking on additional debt from other lenders, which could strain cash flow, increase overall liabilities, and complicate the repayment priority of existing senior debt

• Making dividend payments or other distributions to equity holders, which diverts cash away from the business

• Selling off major assets that are vital to the business's core operations, which could be a concern in an asset-based lending scenario

• Engaging in a merger or acquisition, such as a leveraged buyout (LBO), that fundamentally changes the company's ownership or strategy

Financial covenants

Financial loan covenants require a borrower to maintain a specific level of financial health, measured by key financial ratios and metrics. These are often the most closely watched covenants because they provide a direct, data-driven view of the company's performance, though the maintenance covenants presence varies by deal size: While two-thirds of deals under $250 million have them, that figure drops to just 7% for deals over $500 million. They act as quantitative guardrails, ensuring the borrower's financial performance stays within an agreed-upon range.

Some of the most common financial covenants are:

Leverage and coverage ratios

These covenants limit the amount of debt a company can sustain relative to its cash flow or earnings.

• Leverage ratio (e.g., total debt, EBITDA): This covenant limits the amount of debt, which can include instruments like mezzanine debt, a company can have relative to its earnings (often EBITDA). It ensures the company does not become over-leveraged, which would make it more difficult to handle its debt payments if its business slows down.

• Debt service coverage ratio (DSCR): This covenant requires a company to generate enough cash flow to cover its total debt payments (principal plus interest) by a certain margin. It provides a buffer, giving the lender confidence that the borrower can make its payments even if earnings dip unexpectedly.

• Interest coverage ratio (ICR): This covenant requires a borrower to maintain a minimum ratio of its earnings before interest and taxes (EBIT) relative to its interest expense. It measures the company's ability to service only the interest portion of its debt obligations from operating earnings.

Profitability and performance

These are performance metrics that require the borrower to meet or exceed a minimum level of earnings.

• Minimum profitability (e.g., EBITDA or net income): This covenant requires the borrower to achieve or exceed a minimum level of earnings over a specified period. The metric used is typically EBITDA or net income. It is a key measure of the company's core operating health and ability to generate value, ensuring the business remains fundamentally viable.

Liquidity and working capital

These covenants ensure the borrower has sufficient short-term assets to cover its short-term liabilities.

• Minimum liquidity (e.g., current ratio or working capital): This covenant requires the borrower to maintain enough resources to meet immediate obligations.

  • Current ratio: Requires the borrower to maintain a ratio of current assets to current liabilities above a specified number (e.g., 1.25 to 1).

  • Minimum working capital: Alternatively, it may require maintaining a minimum absolute dollar amount for working capital (current assets minus current liabilities).

Loan covenants from the fund manager's perspective

In the private markets, the managers of various fund structures, such as a fund's general partner (GP) or chief financial officer (CFO), often sit on both sides of the table. They act as a borrower when securing financing for their own fund and as a lender when providing capital to their portfolio companies, sometimes through a co-investment vehicle. This dual role requires a comprehensive understanding of how covenants work from each perspective, as they must manage their own obligations while enforcing those of their investments.

Managing fund-level covenants

Many funds use subscription lines of credit, also known as capital call lines, to manage cash flow and deploy capital into investments quickly. When a fund uses such a credit line to bridge funding before making a capital call, it becomes the borrower and must adhere to the covenants set by the financial institution providing the loan. Managing these obligations is a key responsibility for the fund's leadership, as a breach could impact the fund's ability to operate.

Monitoring portfolio-level covenants

When a private credit fund issues a loan to a company, the fund manager becomes the lender, overseeing a process that requires dedicated private credit solutions to manage effectively. In this role, it is the manager's fiduciary duty to their own investors—the limited partners (LP)—to rigorously monitor the covenants of every loan in their portfolio. A failure to track a portfolio company's compliance puts the LPs' capital at risk and represents a breach of the manager's duty, as defined in the limited partnership agreement (LPA).

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The operational challenge of covenant management

For a fund CFO, the loan operations involved in tracking dozens of unique covenants across a portfolio of loans can be an immense challenge. Loan agreements are often lengthy and complex documents, especially for highly leveraged firms, so using manual tools like spreadsheets and email threads to manage financial compliance is not only time-consuming but also fraught with risk.

This complexity creates a significant administrative burden and increases the likelihood of human error. For a firm like Legalist, which scaled from a small amount of assets under management to over a billion, efficiency across all operations is critical. As CFO Brian Montgomery knows, manual systems can be full of tiny errors that can have a major impact: “Having everything automated in Carta helps. Other admins build their own systems and they’re full of tiny errors—even a dollar here and there can make a difference. With Carta, if your inputs are correct, your outcomes are consistent,” says Montgomery.

What happens when a loan covenant is breached?

A covenant breach, also known as a covenant violation or technical default, occurs when a borrower fails to meet one of the conditions in the loan agreement; however, it's important to note that these covenant defaults often lead to renegotiated terms of the loan rather than a true payment default. This does not always mean the loan is immediately due and payable, but it does give the lender the right to review the situation and decide on a course of action. It is a significant event that shifts the power dynamic in the relationship, giving the lender more control.

The consequences of a breach can vary depending on its severity and the lender's discretion.

• Waiver: For a minor, one-time issue, a lender might issue a waiver, formally forgiving the breach and allowing the loan to continue under its original terms

• Amendment: The lender may require an amendment to the loan agreement, which could involve increasing the interest rate, adding new covenants, charging a fee, or engaging in a restructuring of the deal

• Acceleration: In the most severe cases, the lender can exercise its right to accelerate the loan, demanding immediate repayment of the entire outstanding balance

In these situations, having a clean, auditable record of all covenant tests, communications, and financial data is vital. A centralized platform can make this process transparent and efficient, especially when auditors, regulators, or LPs ask for proof of compliance and monitoring activities for requirements like anti-money laundering (AML) and know your customer (KYC).

Negotiating loan covenants

It’s important to remember that loan covenants are not set in stone; they are negotiable before a loan agreement is signed. Both business owners and lenders have an interest in establishing terms that are fair, realistic, and supportive of the company's long-term success. While investor-friendly terms might seem like a necessary compromise to close a funding round, a covenant that is too restrictive can stifle your company's growth. 

According to legal experts who work with startups and VCs, accepting terms like participating preferred shares or a large liquidation preference could hamstring the company down the line. These structures can complicate your cap table, make it more difficult to bring on future investors, and limit returns for employees, which makes your equity compensation less attractive for hiring top talent.

During negotiations, you should advocate for financial targets that are achievable based on your business plan and projections. It is also wise to discuss the specific definitions used in calculations, such as how Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) is defined, as small changes can have a big impact on the results.

It can also be beneficial to negotiate for stepped covenants, which allow the business to grow into compliance over time. For example, a leverage ratio covenant might start at a higher level and gradually decrease as the company's earnings are expected to increase. This approach acknowledges the company's growth trajectory and sets it up for success rather than an immediate breach.

Automating covenant compliance with Carta

The solution to the operational challenges of manual covenant tracking is a purpose-built technology platform. Carta Loan Operations is designed specifically for private credit funds to automate the most difficult and error-prone parts of covenant management. The software helps track compliance deadlines, sends automated reminders, and calculates financial ratios directly from integrated financial data.

This automation transforms covenant management from a reactive, manual process into a proactive, streamlined workflow. It frees up your finance team from tedious data entry and allows them to focus on more strategic analysis.

To see how Carta can streamline your private credit loan operations, request a demo.

Frequently asked questions about loan covenants

What is the difference between a maintenance and an incurrence covenant?

A maintenance covenant requires the borrower to meet certain financial metrics on a regular basis, such as quarterly. An incurrence covenant is only tested if the borrower takes a specific action, like attempting to take on more debt.

Are loan covenants common in venture debt?

Yes, venture debt agreements rely heavily on covenants. These often include both financial metrics and non-financial requirements, such as providing the lender with regular business updates and performance reports.

How does a floating interest rate impact covenant calculations

A floating interest rate can directly affect interest coverage ratios because the amount of interest paid changes over time. This is a key variable for borrowers, just as the fund's own hurdle rate is an important benchmark for its investors.