Incurrence Covenant: a Worked Example

A lender's position worsens in two ways: the business earns less, or the business does something that puts more claims ahead of or beside the lender, such as more debt, more security, or cash paid out to the owners. A maintenance covenant watches the first. An incurrence covenant watches the second, and only the second. It lets the borrower run its business without asking permission each quarter, while ensuring that any step which adds risk is taken only if the business can carry it on the numbers at the time.

The structure is the backbone of high-yield bonds, where many holders cannot practically negotiate a waiver every quarter, and of covenant-lite term loans to sponsor-backed companies, in UK and European deals and in the larger Australian deals written on those terms. In bank lending to mid-sized businesses in New Zealand and Australia, restrictions are more often written flat: no new debt, security or distributions without the bank's consent, subject to small exceptions. Some bank facilities do add an incurrence-style condition, such as allowing a dividend only if the leverage covenant would still be met after paying it.

Three features decide what the test allows. It is pro forma: the ratio is calculated as though the transaction had happened at the start of the twelve-month period, so an acquired business's earnings count in full on day one. It depends on definitions: what counts as EBITDA, including any expected cost savings the document lets the borrower add, and what counts as debt. And it sits beside baskets. Most restrictions have permitted baskets that allow fixed amounts of debt, security or payments regardless of the ratio, so failing the test closes only one door among several. Restricted payments often also have a builder basket, which grows with a share of retained earnings and in many documents can be used only while the ratio test is met.

A sponsor-backed waste-collection company, constructed for this page, has debt of US$150m and twelve-month EBITDA of US$42m. Its documents allow new debt if pro forma total leverage stays at or below 4.50 times, a level that belongs to the example. It plans to buy a regional competitor earning US$9m, funded with US$60m of new borrowing.

The acquisition passes because the target's earnings are counted as if the company had owned it all year. If the document also lets the company add expected cost savings, the same test would permit US$93m rather than US$79.5m, which is why lenders read the pro forma EBITDA definition and any add-back cap as carefully as the ratio itself.

A year later the combined business earns US$36m and debt is still US$210m:

Nothing has been breached. The company cannot incur more debt under the ratio, but its baskets for other debt and security remain open, and nothing in the covenant gives the lenders a seat at the table while leverage climbs. A maintenance covenant set at 4.50 times would have produced a breach months earlier.

DEFINED IN ONE PARAGRAPH → · DEBT TO EBITDA → · LOAN COVENANTS, EXPLAINED →

A maintenance covenant is tested at every test date, whether or not the borrower has done anything, and failing it is an event of default. An incurrence covenant is tested only when the borrower proposes a restricted step, and failing it simply means the step cannot be taken. A borrower breaches an incurrence covenant only by going ahead anyway, or by misstating the calculation, and that breach is then a default like any other.

The two can sit in the same deal. A covenant-lite term loan carries incurrence tests, while the revolving facility beside it carries a springing covenant, a maintenance test that applies once the revolver is drawn beyond a set share. Where both an incurrence test and a maintenance test use leverage, they can be set at different levels, and a lender checks that the incurrence level leaves room so that a permitted borrowing does not tip the business straight into a maintenance breach.

The incurrence test decides how much the borrower can change its capital structure without asking, so the lender reads it as a measure of how far the business it approved can drift from the business it will be owed by. At origination the credit paper works out the debt the documents would allow on the forecast, ratio debt and baskets together, not only the debt drawn on day one. During the life of the loan the lender watches the actions the tests permit, since an acquisition, a refinancing or a dividend recapitalisation is the moment its position changes. For a bank competing against an institutional offer, the question is what an incurrence-only structure would let the borrower do that its own consent-based facility would have stopped.