A covenant is a requirement or metric on debt that is common in LBOs; this requirement or metric must be met or else the borrower will technically be in default. The details of the covenant can be found in the credit agreement.
Maintenance covenants require the borrower to meet certain financial metrics, typically tracking them on a last twelve months (LTM) basis every month. The need to meet maintenance covenants on a monthly basis is often the primary impetus for building a monthly model.
Incurrence covenants prevent the borrower from performing specific actions, such as paying out dividends before repaying the debt, or executing add-on acquisitions without meeting certain metrics or requirements.
Common maintenance covenants include:
- Leverage ratio: Debt / LTM EBITDA
- Interest coverage ratio: EBITDA / interest expense, or
(EBITDA – capex) / (cash interest expense + mandatory debt repayment)
- Debt to Assets
- Debt to Equity
- Loan to Value