Maintenance Vs Incurrence
Private credit covenants are contractual tests that measure a borrower’s financial condition and restrict certain actions. Maintenance covenants require the borrower to stay within limits on an ongoing basis, usually tested at each reporting date. Incurrence covenants restrict actions only when a specific event happens, such as taking on new debt, paying dividends, or making certain investments. The same financial ratios can appear in both covenant types, but the timing of the breach changes the borrower’s options and the lender’s leverage.
In practice, maintenance covenants often show up as leverage or interest coverage limits that are measured quarterly or semiannually. Incurrence covenants often appear as “no additional indebtedness” unless a ratio is met, or “restricted payments only if” a test is satisfied. A borrower can be “in compliance” with an incurrence covenant most of the time, then fail it at the moment it tries to do something. That difference drives how teams plan refinancing, equity issuance, and asset transactions.
One small detail that matters: covenant definitions frequently include or exclude items like cash, restricted cash, EBITDA add-backs, and lease liabilities. I’ve seen covenant packages where the ratio looks conservative in the term sheet, then turns out to be less strict after the final definitions—version numbers on the credit agreement drafts can help track those changes (for example, “v3.2” dated 2024-11-06 in a diligence folder).
Where People Get Tripped
Many misunderstandings start with the word “default.” A maintenance covenant breach can create an event of default or a default-like consequence at the next test date, even if the borrower never attempted a restricted action. Incurrence covenants can feel safer until a planned transaction triggers the test, and then the borrower discovers the ratio is calculated differently than expected.
Another common error is treating the ratio as a single number rather than a model with moving parts. EBITDA adjustments, net debt definitions, and interest expense treatment can change quarter to quarter. If the agreement uses a trailing twelve-month measure for leverage but a quarterly measure for interest coverage, the borrower’s headroom can swing in ways that surprise finance teams.
People also underestimate dependencies on reporting cadence and data quality. Covenant testing relies on the borrower’s financial statements, management accounts, and sometimes a third-party valuation or inventory methodology. If the lender requires a specific reporting package, delays in closing the books can delay covenant calculations, which can affect whether waivers or amendments are needed.
Finally, covenant outcomes depend on the lender’s remedies and cure rights. Some agreements include cure periods, equity cures, or the ability to reset covenants after a refinancing. Others treat breaches as immediate defaults with limited cure mechanics. The legal text around notice, cure, and waiver fees often matters as much as the ratio itself.
How To Read The Language
Map Each Covenant Trigger
Start by listing every covenant test and labeling it as maintenance or incurrence based on the trigger language. Maintenance covenants typically reference “at each testing date” or “on a quarterly basis.” Incurrence covenants typically reference “in connection with” a transaction, such as incurring additional debt or making restricted payments. Then record the exact calculation period (for example, trailing twelve months versus fiscal quarter) and the measurement basis (GAAP, IFRS, or a defined “Adjusted” metric).
A practical method is to build a one-page covenant map that includes: test name, ratio formula, measurement period, testing frequency, and the action that becomes restricted. This avoids the common failure mode where teams model only the ratio and ignore the transaction trigger. I’ve seen diligence checklists that stop at “leverage covenant exists,” then miss that the incurrence covenant blocks dividends unless a separate net leverage test is met.
Model Headroom With Definitions
Model covenant headroom using the agreement’s definitions, not generic templates. For leverage, confirm whether net debt includes debt-like items such as preferred equity, capital leases, or letters of credit. For interest coverage, confirm whether interest expense is gross or net of interest income, and whether it uses cash interest or accrual interest. For EBITDA-based tests, list each add-back and check whether it is capped, recurring-only, or subject to “reasonable” or “in the lender’s discretion” language.
Use a scenario set that matches real borrower decisions: a base case, a downside case, and a “transaction case” that reflects the planned action’s accounting impact. If you are a borrower planning a dividend or acquisition, model the covenant test immediately after the transaction, not before. If you are an investor, ask how the borrower’s quarterly reporting will capture one-time items so you can judge whether the model will be stable.
Realistic outcomes depend on the business, but a common pattern is that maintenance covenants require tighter ongoing headroom because a single quarter can breach. Incurrence covenants can tolerate temporary weakness if the borrower avoids triggering events, yet the borrower still needs enough headroom at the moment of the action.
Plan Around Testing Dates
For maintenance covenants, plan around the testing date calendar and the reporting timeline. If the agreement tests on a quarter-end basis, the borrower’s leverage can worsen between reporting dates due to working capital swings, then improve later. That creates a risk that the quarter-end snapshot breaches even if the business recovers by the next quarter. Some agreements allow interim calculations or provide notice requirements that can reduce surprise, but those provisions vary.
For incurrence covenants, plan around the transaction closing mechanics. Many incurrence tests are measured “as of” a date tied to the transaction, and the agreement may require pro forma calculations. If the transaction includes debt issuance, equity issuance, or asset sales, the pro forma treatment can materially change the ratio. A mild frustration for finance teams is that the pro forma rules often live in a separate section, and people miss them until the last draft of the board memo.
Use Amendments And Cures Carefully
Review the agreement’s amendment and waiver process, including required lender consent thresholds and any fees. Maintenance covenant breaches may trigger default remedies, but many deals include cure rights such as equity contributions, refinancing, or temporary waivers. Incurrence covenant failures typically block the restricted action rather than triggering a default, unless the agreement treats the failure as an event of default.
Ask whether the agreement permits “equity cures” and how they are calculated. Some agreements allow a borrower to cure a leverage breach by contributing cash as equity, which reduces net leverage. Others limit the amount, require lender approval, or restrict the timing. If cure mechanics exist, model the cost and timing, because waivers and amendments can take weeks and may require updated financial statements.
Also check whether the lender can tighten covenants in future amendments. Some agreements include “springing” covenants after a refinancing or after a leverage step-down. Those provisions can turn a maintenance covenant into a more restrictive test later, even if the initial covenant package looks manageable.
Educational Case Examples
Case 1: Maintenance breach after a quarter-end working capital swing. A mid-market manufacturer has a quarterly maintenance leverage covenant tested on the last day of each fiscal quarter. In Q2, inventory builds and accounts receivable collection slows, pushing net debt higher at quarter-end. The business improves in July, but the covenant test uses the quarter-end snapshot, so the leverage ratio breaches when the lender receives the Q2 financial package. The borrower negotiates a waiver and uses an equity cure permitted by the agreement, but the waiver requires updated reporting and a fee.
Case 2: Incurrence covenant blocks a planned acquisition. A services company plans to acquire a smaller competitor and fund it with new term debt. The credit agreement includes an incurrence covenant that restricts additional debt unless a leverage test is met on a pro forma basis. The borrower’s trailing leverage looks acceptable, but the pro forma calculation includes the acquisition debt and the target’s leverage, which pushes the ratio above the threshold. The borrower delays the acquisition, restructures the financing with more equity, or seeks a lender waiver that changes the test definition for that specific transaction.
Comparison Checklist
| Feature | Maintenance Covenant | Incurrence Covenant | What To Check |
|---|---|---|---|
| Trigger timing | Tested at each reporting/testing date | Triggered by a restricted action | Look for “at each testing date” versus “in connection with” language |
| Default risk | Breach can create default or default-like remedies | Failure blocks the action; default depends on drafting | Read event-of-default section and cure rights |
| Modeling focus | Ongoing headroom across quarters | Pro forma headroom at transaction close | Confirm measurement period and pro forma rules |
| Operational planning | Quarter-end snapshot management | Transaction structuring and timing | Align finance close calendar with testing dates |
| Common surprises | Definitions and quarter-end working capital swings | Pro forma treatment and add-back caps | Reconcile lender definitions to your reporting model |
If you prefer a checklist, use this sequence: identify each covenant type, extract the exact ratio definitions, map the testing dates or transaction triggers, build a model that matches the agreement’s accounting basis, then run scenarios that mirror the next 90–180 days of decisions. That time window catches most covenant-relevant actions, like refinancing, dividends, and acquisitions.
Common Mistakes To Avoid
One frequent mistake is relying on a term sheet summary rather than the final credit agreement definitions. Term sheets often describe leverage tests in plain language, while the agreement defines EBITDA, net debt, and permitted add-backs in detail. The gap between those documents can change the ratio enough to flip compliance.
Another mistake is assuming that “compliance” means “no action needed.” Maintenance covenants require ongoing monitoring, and incurrence covenants require monitoring of planned actions. If the borrower’s internal reporting cadence lags the lender’s test schedule, the borrower can miss early warning signals and end up negotiating under time pressure.
People also confuse covenant headroom with business health. A borrower can have covenant headroom while facing liquidity stress, especially if the covenant uses accrual-based metrics that do not reflect cash. Conversely, a borrower can breach a ratio due to accounting classification changes without a true deterioration in cash generation. Covenant analysis should connect to cash flow and liquidity, not only ratios.
Finally, teams sometimes treat waivers as routine. Waiver terms can include fees, tighter future covenants, and limits on future restricted payments. If the agreement requires lender consent thresholds, a borrower may not control outcomes even when the breach looks temporary. That uncertainty is why the agreement’s cure and amendment mechanics matter.
FAQ
What Makes A Covenant “Maintenance”?
A maintenance covenant is tested at set reporting or testing dates, and the borrower must meet the ratio continuously across those dates. Breach timing aligns with the test date, not with a specific transaction.
What Makes A Covenant “Incurrence”?
An incurrence covenant restricts a specific action unless a test is satisfied at the time of that action. The borrower can remain compliant until it triggers the covenant through a transaction.
Do Both Covenant Types Use The Same Ratios?
They often use similar ratios such as leverage or interest coverage, but the measurement period, pro forma rules, and definitions can differ. The agreement’s calculation section controls the outcome.
Can A Borrower Cure A Covenant Breach?
Some agreements include cure rights such as equity contributions, refinancing, or temporary waivers, but the mechanics vary by drafting. The event-of-default and cure provisions determine whether a cure is available and how quickly it must occur.
How Should Investors Model Covenant Risk?
Investors typically model both ongoing maintenance headroom and transaction-specific incurrence tests using the agreement’s definitions. They also track reporting cadence, expected add-backs, and the lender’s amendment or waiver behavior, which can affect recovery and timing.
Author's Insight
Maintenance and incurrence covenants differ mainly by timing: maintenance tests happen on a schedule, while incurrence tests happen when the borrower takes a restricted action. The ratio’s meaning depends on definitions, including how net debt and EBITDA are constructed, and those definitions often change the practical risk more than the headline ratio. Covenant analysis benefits from a model that mirrors the credit agreement’s measurement basis and pro forma rules, not a generic leverage template. When cure rights and waiver mechanics exist, they shape the real-world consequences of a breach, including cost and timing.
Key Takeaways
- Maintenance covenants test compliance at reporting dates, so quarter-end snapshots can trigger breaches even without new transactions.
- Incurrence covenants restrict actions, so the borrower’s risk concentrates around planned debt, dividends, and acquisitions.
- Definitions drive outcomes: EBITDA add-backs, net debt components, and pro forma rules can change the ratio materially.
- Model headroom with scenarios that match upcoming decisions, then review cure and waiver mechanics to understand consequences and timing.
