Definition of covenant in finance

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. The covenant is simply any specified agreement, the most common one being the Debt / EBITDA ratio and the Loan to Value ratio in real estate.

This is important because when calculating the amount available for debt repayments or the total amount able to be borrowed to finance a transaction, covenants will determine the amount of money that can be borrowed, the value of bonds that can be issued, the total free cash flow which can be used to pay debt, etc.

The purpose of a covenant is to give the lender and the target company security that certain activities will not be carried out and that the company will not be run unsustainably. If the terms of a covenant are violated, there will be a penalty incurred. This penalty could vary from simply repairing a technical default to losing control of the company under a payment default or acceleration of the funds due.

Breaking a covenant is often referred to as a default, and this can be a technical default (the company is still paying its debts) or an actual default (the company misses a payment).

If a covenant is breached, the borrower typically has to put up equity or pay extra money and if it is unable to do this, then the entire amount of the loan is due and there could even be a firesale at massively reduced asset prices.

Some of the most commonly used covenants are:

• Debt / EBITDA
• Debt to Assets
• Debt to Equity
• EBIT / Interest
• Loan to Value

Covenants can be often be waived at the discretion of the lender. For example, in a situation of exceptional circumstances whilst the company in question is still sound and stable. Enforcing or abiding by covenants can actually have negative consequences for both parties as the restrictions may lead to reduced efficiences and lower profits than would otherwise be experienced.