A maintenance covenant is a financial test the business must pass on a schedule, usually every quarter, whether or not it does anything: for example, a minimum debt service coverage or a maximum leverage. Miss it and the loan is in default. An incurrence covenant is tested only when the business takes a specific action, such as borrowing more, paying a dividend or making an acquisition; fail it and you simply cannot take that action. Bank and private credit loans to lower-middle-market companies mostly carry maintenance covenants, so the cushion set at closing matters more than the headline rate.
- Maintenance covenant
- Tested on a schedule, usually quarterly, no matter what
- Incurrence covenant
- Tested only when the company takes a named action
- Failing a maintenance test
- An event of default: waiver, amendment or worse
- Failing an incurrence test
- The action is blocked; no default if you don't take it
- Lower middle market
- Mostly maintenance tests, often with incurrence tests beside them
- What to negotiate
- Cushion, step-downs and the EBITDA definition
The difference in one example
Suppose a loan agreement includes a maximum leverage test: funded debt divided by EBITDA may not exceed a set level. Written as a maintenance covenant, it is measured at the end of every quarter on the trailing twelve months. If a large customer leaves and EBITDA falls, leverage rises on its own, even though the company borrowed nothing, and a breach can follow. Written as an incurrence covenant, the same ratio is measured only when the company wants to borrow more, pay a distribution or buy another business. If EBITDA falls, nothing happens until the company tries one of those things; then the test tells it no.
So a maintenance covenant polices the company's performance, and an incurrence covenant polices the company's choices. The first gives the lender an early seat at the table when results weaken. The second only limits what management can do to make the lender's position worse. That is why lenders who hold a loan to maturity and cannot easily sell it, which describes most lenders to lower-middle-market companies, prefer maintenance tests.
Side by side
| Maintenance covenant | Incurrence covenant | |
|---|---|---|
| When tested | Every period, usually quarterly, sometimes monthly or annually | Only when the company takes a defined action |
| What triggers a problem | Results weakening, even with no action by the company | The company trying to borrow, pay out, acquire or sell |
| Consequence of failing | Event of default, unless waived or cured | The action is not permitted |
| Typical tests | Minimum DSCR or FCCR, maximum leverage, minimum liquidity or net worth | Pro forma leverage or coverage for new debt, distributions, acquisitions |
| How measured | Trailing results at each test date | Pro forma, as if the action had already happened |
| Reporting | Compliance certificate every test period | A calculation delivered when the action is proposed |
| Common in | Bank loans, most private credit, SBIC and mezzanine loans | Larger syndicated loans and bonds; as a second layer in smaller loans |
| Lender's leverage | High: a breach reopens terms | Low: only over the specific action |
Which lenders use which in the lower middle market
Loans that carry only incurrence covenants, often called covenant-lite, are mostly a feature of large, widely held loans and bonds, where many investors hold small pieces and no single one wants to monitor the company quarter by quarter. For established private businesses in the lower middle market, the pattern is different:
- Banks usually set one or two maintenance tests, most often a minimum debt service coverage ratio and sometimes a maximum leverage or minimum net worth, tested quarterly or annually. Conventional bank lenders commonly look for debt service coverage of at least 1.25x when they underwrite, and covenant levels are set with that in mind.
- Private credit funds and unitranche lenders commonly test maximum leverage and a minimum fixed charge coverage every quarter, with levels that step down over the life of the loan.
- Asset-based lenders often use a springing covenant: a minimum fixed charge coverage that is tested only when excess availability falls below a threshold. It is a maintenance test that switches on when liquidity gets thin.
- SBA 7(a) lenders underwrite to SBA's coverage minimums at approval and commonly require annual financial reporting; some add an annual coverage covenant. The ongoing covenant package is usually lighter than on a conventional loan.
- Mezzanine and second lien lenders usually test the same ratios as the senior lender, set looser, so the senior lender is the first to see a breach.
Most of these loans also contain incurrence-style limits as a second layer: distributions are allowed only if pro forma coverage stays above a level, acquisitions only if pro forma leverage stays below a set level. Those appear among the negative covenants and restricted payments provisions, not in the financial covenant section.
How testing works in practice
For a maintenance covenant, the company delivers financial statements and a compliance certificate within a set period after each quarter end, showing each ratio calculated exactly as the credit agreement defines it. The measurement is usually trailing twelve months, so a single weak quarter stays in the numbers for a year. Early in a loan, some agreements annualize the months since closing instead, which makes a slow first quarter count several times over.
The definitions carry the real weight. "EBITDA" in a credit agreement is a defined term, and whether it adds back one-time costs, owner compensation above a market level, or acquisition expenses decides how much room the business has. Our page on the covenant EBITDA definition covers what to look for.
For an incurrence covenant, there is no calendar. When the company wants to take a restricted action, it runs the calculation pro forma, as if the new debt, distribution or acquisition had already happened, and delivers it to the lender. If the ratio clears, the action is permitted; many agreements also allow small amounts through fixed-size baskets without any test.
What happens when a test is missed
Missing a maintenance test is an event of default. The lender does not have to call the loan, and usually does not, but it gains the right to. That changes the negotiation. The common sequence is a waiver or amendment, which usually brings a fee, sometimes higher pricing, tighter reporting or a reset of other terms. Some agreements give the owners an equity cure: putting in cash that counts as EBITDA or reduces debt for the test. Unresolved, a breach can trigger default interest and, through cross-default clauses, problems under other loans and leases. Our guide to options after a covenant breach walks through each step.
Failing an incurrence test has no such consequence on its own. The company cannot pay the distribution or take on the new loan, and the business carries on. It becomes a default only if the company goes ahead anyway.
A maintenance breach is decided by results you may not control. An incurrence limit is decided by choices you do. That is why maintenance cushion deserves the attention.
Why cushion at closing matters more than the headline rate
Owners comparing term sheets often choose on rate. With maintenance covenants, the covenant levels and definitions can matter more. Consider two offers for a loan of 3,000 to a company with EBITDA of 1,000.
| Offer A | Offer B | |
|---|---|---|
| Interest rate | Half a point lower | Half a point higher |
| Extra interest per year on 3,000 | None | 15 |
| Maximum leverage covenant | 3.25 times, stepping down each year | 3.75 times, flat |
| EBITDA at which leverage breaches | About 923 | 800 |
| EBITDA can fall before a breach | About 77, under a tenth | 200, a fifth |
Offer A saves 15 a year in interest. It also breaches if EBITDA drops by less than a tenth, which is well within an ordinary bad year for many businesses, and the step-downs shrink that room further as time passes. A single waiver typically costs a fee, legal costs and management time, and gives the lender a chance to reprice. Offer B costs more each year and leaves room for a real downturn.
Lenders usually set covenant levels off their own model's projections with a cushion beneath. Ask which case the covenants were set on and measure headroom in EBITDA, not ratio points. Our page on how much covenant headroom to negotiate takes that further.
What to negotiate before signing
- Levels set off a realistic case, with room for a downturn at every test date, including after each step-down.
- Fewer maintenance tests. One coverage test and one leverage test is common; a third test adds a way to fail.
- Incurrence where possible. Some lenders will accept leverage as an incurrence test for new debt and distributions while keeping only a coverage test as maintenance.
- A springing structure on asset-based lines, so the fixed charge test applies only when availability is tight.
- The EBITDA definition: add-backs, acquired EBITDA, and how one-time costs are treated.
- Test frequency and period: quarterly on trailing twelve months, rather than monthly or annualized.
- Equity cure rights and how many times they can be used.
These terms are easiest to move before a lender is chosen, when it still competes for the loan. Transparent's lender book holds 1,800+ lenders, and the lender package it builds includes a financing model that lays out the covenant tests, so the cushion in each offer can be compared before one is signed. See DSCR vs FCCR for the two coverage tests lenders use most.
Common questions
- Can a lower-middle-market business get a covenant-lite loan?
- Rarely. Loans with only incurrence covenants are mostly made to large companies whose debt is widely held. Lenders to smaller private businesses hold their loans and want quarterly visibility, so they use maintenance tests. What smaller borrowers can negotiate is fewer tests, wider cushion and better definitions.
- Do SBA 7(a) loans have maintenance covenants?
- Usually a lighter set than conventional loans. SBA lenders underwrite to SBA's coverage minimums at approval and commonly require annual financial statements; some include an annual debt service coverage covenant. Read the loan agreement, not just the SBA authorization.
- What is a springing covenant?
- A maintenance test that applies only when a trigger is hit, most often when excess availability under an asset-based line falls below a set level. Until then it is not tested at all.
- Is missing a maintenance covenant the same as missing a payment?
- No. Both are events of default, but a covenant breach with payments current is usually resolved with a waiver or amendment. It still gives the lender the right to change terms, which is why it should be handled early and openly.
- Which is the most common maintenance covenant?
- In lower-middle-market lending, a coverage test: a minimum debt service coverage ratio at banks, and a minimum fixed charge coverage ratio at asset-based and many private credit lenders, often paired with a maximum leverage ratio.