Covenant Mulligan: How a Second Chance Is Drafted

A financial covenant breach, once certified, hands the lender a choice it did not have the day before: waive, reprice, reset or act. For a business with lumpy earnings, a single quarter can fail for reasons that reverse by the next one, and the owners would rather not pay a waiver fee, or put in an equity cure, to cover a dip that will correct itself. A mulligan removes the first breach from the list of events of default and leaves the covenant in place for the next test.

Where it appears it is negotiated, and it is met more often in larger corporate facilities than in leveraged ones: a 2018 law-firm review of European leveraged deals called it rare there. In mid-market bank lending in New Zealand, Australia and the UK the usual position is that a failed financial covenant is an event of default from the first test, subject to any cure right the agreement gives.

Four drafting points do the work. The first is which later breach counts. The published descriptions and filed clauses require a failure at the next test, so a pass in between starts the count again; a looser draft could make any later failure the default. The second is reuse: a clause can say a further mulligan is not available until the covenant has been met for a set number of periods after the last one. The third is what the first breach still triggers. A lender can agree that it is not an event of default and still require something for it, such as more frequent reporting, access to management, or the borrower paying for the lender's advisers. The fourth is the interaction with an equity cure: where both exist, the second failure may become a default only once the cure window has closed without new money.

The wording around the word 'default' matters too. Many agreements use a wider defined term, such as a Default, that includes events which would become events of default with time or notice, and that term can stop new drawings or dividends. A lender reading a mulligan checks whether the disregarded breach is kept out of that wider term as well.

A sponsor-backed veterinary clinic group, constructed for this page, has a net leverage covenant of 5.00 times tested quarterly. The level is the example's. Over five quarters its results are:

The same five results produce four different default dates, depending on the clause:

Under the last draft the lender has watched the group fail three of four tests before it can act, and the business has spent nine months moving away from its covenant. Under the reuse-limited draft it can act a quarter sooner, at December. If the first breach also triggered monthly reporting and adviser access, the lender spent those quarters better informed even without a default to act on.

DEFINED IN ONE PARAGRAPH → · THE TEST DATE → · BANK LOAN VS PRIVATE CREDIT →

An equity cure and a mulligan both stop a breach becoming a default, but the equity cure is bought: the owners inject money and the ratio is recalculated as if it had been there. Under a mulligan the ratio stays failed and nobody pays.

A deemed cure works the other way round from a mulligan. Under a deemed cure the first breach is a default from the day it is certified, and the lender can act on it; the default lapses if the borrower passes the next test before the lender has done so. Under a mulligan the lender has nothing to act on until the later failure. In the example, a deemed cure would have given the lender a default in June that lapsed when September passed, and another in December that stood. Because a deemed-cure default expires with the next pass, a syndicate that wants to use it has to decide before that test.

Neither should be confused with a cure period, which only gives the borrower days to remedy a breach that can be remedied.

The mulligan is decided in the term sheet, usually alongside the covenant level itself, and the two trade against each other: a lender may accept a mulligan in exchange for a tighter level, since a test that cannot bite at the first failure needs less room. Once signed, it changes what a breach means in the credit file. A first failure under a mulligan is not a default, but it is a fact, and the lender's internal grading and watchlist decisions do not have to wait for the contract to catch up. The credit officer records the breach, asks what the borrower expects at the next test, and reads the forecast knowing the next failure is the one that counts.