Incurrence covenant

What Is Incurrence Covenant?

An incurrence covenant is a specific type of financial covenant that requires a borrower to meet certain financial conditions only when undertaking a specified action. Unlike covenants that are continuously tested, an incurrence covenant is triggered by a voluntary event or action initiated by the borrower, such as a new debt issuance, a significant dividend payment, a share repurchase, or an acquisition or divestiture³⁰, ³¹. These covenants are a crucial component of loan agreements and bond issues within the broader category of debt covenants. Their primary purpose is to protect the interests of lenders by preventing the borrower from taking actions that could materially weaken its financial position or increase the risk of default²⁸, ²⁹.

History and Origin

The concept of debt covenants emerged as a mechanism for lenders to mitigate agency problems between management and debt holders, ensuring that borrowers' actions align with the interests of those providing capital²⁷. While specific historical origins of the distinct "incurrence covenant" are not widely documented as a single invention, their rise is closely associated with the evolution of the leveraged finance market.

Incurrence covenants gained significant prominence with the growth of the "covenant-lite" (or "cov-lite") loan market, particularly in the years leading up to and following the 2008 global financial crisis²⁶. Historically, many loans featured "maintenance covenants" that required continuous compliance with financial ratios. However, as capital markets became more competitive and borrowers sought greater operational flexibility, incurrence covenants became more prevalent, especially in high-yield bonds and leveraged loans. This shift meant that while lenders still had protections, these protections were often triggered by specific actions rather than continuous monitoring, reflecting a move towards less restrictive debt agreements²⁵.

Key Takeaways

• An incurrence covenant is a debt covenant triggered only when a borrower takes a specific, voluntary action.
• Common trigger events include new debt issuance, dividend payments, mergers, or acquisitions.
• These covenants aim to protect lenders by ensuring the borrower maintains certain financial health metrics after undertaking a specified action.
• If the borrower cannot meet the covenant's terms after the proposed action, the action is typically prohibited.
• Incurrence covenants are distinct from maintenance covenants, which require continuous compliance with financial ratios.

Interpreting the Incurrence Covenant

Interpreting an incurrence covenant involves understanding the specific financial metrics it references and the actions that trigger its application. For example, an incurrence covenant might state that a company cannot incur additional debt if, on a pro forma basis, its leverage ratio (e.g., total debt to EBITDA) would exceed a certain threshold²³, ²⁴. This means that the company's existing leverage ratio is not continuously tested against this covenant; rather, the test only applies when the company intends to take on more debt. If the proposed debt issuance would cause the leverage ratio to breach the specified limit, the company is typically prohibited from taking that action under the terms of the loan agreement.

The effectiveness of incurrence covenants lies in their proactive nature for specific events. They don't penalize a company for a deteriorating balance sheet due to general market conditions or operational underperformance (unless those conditions trigger a separate maintenance covenant); instead, they control specific, discretionary actions that could further exacerbate financial risk²².

Hypothetical Example

Consider "Alpha Corp," which has an existing loan agreement with "Bank Beta." The agreement includes an incurrence covenant stating that Alpha Corp cannot undertake a new debt issuance if its Debt-to-EBITDA ratio, calculated after the new debt, would exceed 4.0x.

Currently, Alpha Corp has $100 million in debt and an EBITDA of $30 million, resulting in a Debt-to-EBITDA ratio of approximately 3.33x ($100M / $30M).

Alpha Corp is considering issuing an additional $25 million in new debt to fund a merger.
To determine if this action is permitted, Alpha Corp must calculate its pro forma Debt-to-EBITDA ratio:
New Total Debt = $100 million (existing) + $25 million (new) = $125 million
Assuming EBITDA remains $30 million immediately after the debt issuance:
Pro Forma Debt-to-EBITDA = $125 million / $30 million = 4.17x

Since 4.17x is greater than the 4.0x limit set by the incurrence covenant, Alpha Corp would be in breach of its loan agreement if it proceeded with the $25 million debt issuance. To comply, Alpha Corp would either need to reduce the amount of new debt, increase its EBITDA before the issuance, or negotiate a waiver from Bank Beta.

Practical Applications

Incurrence covenants are widely used in various financial instruments and transactions to manage and mitigate risk for lenders.

• High-Yield Bonds and Leveraged Loans: These debt instruments frequently employ incurrence covenants, often forming the core of "covenant-lite" structures. They give borrowers more operational flexibility than traditional loans but still provide critical protection against specific actions like excessive new debt issuance or aggressive dividend payments that could erode credit quality²¹.
• Mergers and Acquisitions (M&A): When a company plans an acquisition that requires significant financing, incurrence covenants in existing debt agreements may restrict its ability to take on additional debt or deploy capital for the deal unless specific financial thresholds are met²⁰. This helps existing lenders ensure the acquiring company's post-M&A financial health remains acceptable.
• Private Equity Transactions: In leveraged buyouts (LBOs), incurrence covenants play a crucial role in structuring the debt financing. They manage the private equity firm's ability to extract value (e.g., through large dividends) or to layer on more debt post-acquisition, safeguarding the interests of the various lenders involved.
• Corporate Restructurings: During periods of financial distress or restructuring, incurrence covenants can dictate what actions a company can take to raise new capital or dispose of assets, thereby protecting existing creditors' claims and ensuring an orderly process.

In all these applications, incurrence covenants serve as a tripwire, ensuring that discretionary corporate actions do not unduly jeopardize the borrower's financial stability from the perspective of its debt providers¹⁸, ¹⁹.

Limitations and Criticisms

While incurrence covenants offer valuable protections, they also come with certain limitations and have faced criticisms, particularly in the context of the "covenant-lite" trend.

One primary criticism is that because they are only triggered by specific actions, incurrence covenants provide less continuous oversight compared to maintenance covenants¹⁶, ¹⁷. A company's financial health could deteriorate significantly due to operational issues or market downturns, and unless the company initiates a triggering action, no covenant breach would occur. This can limit a lender's ability to intervene early to prevent a default¹⁵. Research by the Federal Reserve Bank of Boston suggests that while incurrence covenants do impose constraints, they preserve equity control rights, and the restrictions are triggered only when the threshold is crossed, rather than requiring continuous compliance¹⁴.

Furthermore, some argue that the rise of incurrence-only covenants in leveraged finance has shifted more risk to lenders and bondholders. Firms with only incurrence covenants (often referred to as "cov-lite" loans) may experience a significant drop in investment and market value when covenant restrictions are triggered, even without a formal default or bankruptcy, indicating a shock amplification mechanism through these contractual restrictions¹³. This highlights a potential drawback where the absence of continuous monitoring might delay necessary corrective actions, ultimately making the eventual impact more severe¹². The design of debt contracts, including the strictness of covenants, can influence firm performance, though stricter covenants may sometimes constrain managerial flexibility¹¹.

Incurrence Covenant vs. Maintenance Covenant

Incurrence covenants and maintenance covenants are the two primary types of financial covenants, differing fundamentally in their trigger mechanism and monitoring frequency.

The key distinction lies in the timing of the compliance test: an incurrence covenant is a gate that must be passed before a specific action, while a maintenance covenant is a continuous financial health check.

FAQs

What is the primary purpose of an incurrence covenant?

The primary purpose of an incurrence covenant is to protect lenders by preventing a borrower from taking specific voluntary actions that could significantly worsen its financial standing or increase the risk of default⁵.

What types of actions typically trigger an incurrence covenant?

Actions that commonly trigger an incurrence covenant include new debt issuance, large dividend payments, significant share repurchases, mergers, acquisitions, or divestitures⁴.

How does an incurrence covenant differ from a maintenance covenant?

An incurrence covenant is only tested when a specific action is incurred by the borrower, whereas a maintenance covenant requires the borrower to maintain certain financial ratios or conditions continuously, typically tested on a regular schedule (e.g., quarterly)³.

Are incurrence covenants considered more or less restrictive than maintenance covenants?

Incurrence covenants are generally considered less restrictive than maintenance covenants for borrowers, as they provide more operational flexibility by not requiring continuous compliance with financial ratios². This is why they are a hallmark of "covenant-lite" debt structures.

What happens if a borrower violates an incurrence covenant?

If a borrower attempts to take an action that would violate an incurrence covenant, the action is typically prohibited under the terms of the loan agreement. Proceeding with such an action without a waiver from the lender would constitute a breach of the covenant, which could lead to a default on the loan¹.