Covenant packages separate good deals from disasters. We walk through the specific language we scrutinize in asset-backed lending agreements—maintenance vs. incurrence, cure periods, and what happens when things go sideways.
Most specialty credit opportunities come with covenant packages that look reasonable at first glance. The terms are there: maximum LTV ratios, minimum debt service coverage, collateral reporting requirements. But the difference between a protective covenant structure and one that leaves you exposed often comes down to three or four words buried in legal prose.
We've seen structures where the borrower had complete discretion to redefine EBITDA. Others where "material adverse change" was so narrowly defined that it essentially never applied. And plenty where cure periods were so generous that by the time you could act, the collateral had already deteriorated significantly.
The first distinction that matters: maintenance covenants must be satisfied continuously (typically tested quarterly), while incurrence covenants only apply when the borrower takes a specific action—raising new debt, making distributions, or selling assets.
In asset-backed structures, we strongly prefer maintenance covenants for anything related to collateral quality. If you're lending against a portfolio of receivables, equipment, or intellectual property, you need real-time visibility into deterioration. An incurrence covenant on loan-to-value only helps you if the borrower happens to be raising new money when values drop—which is exactly when they won't be.
That said, incurrence covenants make sense for restrictions on new debt or distributions. We don't need quarterly confirmation that they haven't raised a new senior secured loan—we need to be in the approval path if they try to.
Most investors skip straight to the covenant thresholds. We start with definitions, because that's where borrower-friendly structures hide their flexibility.
Look at how "EBITDA" or "Adjusted EBITDA" is defined. Can the borrower add back non-recurring expenses? What counts as non-recurring? We've seen structures where acquisition-related costs, integration expenses, and "business optimization" charges all qualified—meaning reported EBITDA had almost no relationship to actual cash generation.
Similarly, pay attention to how "collateral value" gets calculated. Is it based on orderly liquidation value (OLV), appraised value, or borrower-provided marks? Who selects the appraiser? How often are valuations updated? We've walked away from deals where collateral valuation was effectively at the borrower's discretion.
When a covenant is breached, two questions matter: how quickly do you know about it, and how much time does the borrower have to fix it?
Standard cure periods run 30-45 days for financial covenants, but we've seen structures with 60, 90, or even 120-day cure windows. In a deteriorating credit, three months is an eternity. Collateral can disappear. Key employees leave. Customer relationships erode. By the time your cure period expires, you may be in a much worse position than when the breach occurred.
Equally important: notice requirements. Does the borrower have to proactively notify you of a breach, or do you only find out when you receive quarterly financials? We require immediate written notice of any covenant breach, material adverse change, or litigation above a defined threshold—not in the next scheduled report, but within 48-72 hours.
Borrowers will ask for flexibility to make distributions to equity holders, pay management fees to sponsors, or sell assets without lender consent. The question isn't whether to allow these activities—it's under what conditions.
For distributions, we typically require compliance with all financial covenants on a pro forma basis (after giving effect to the distribution) plus a cushion. If your maximum leverage covenant is 3.0x, we might require pro forma leverage below 2.5x before distributions are permitted. The cushion ensures you're not paying out cash right up to the edge of a covenant breach.
For asset sales, we focus on three things: consent rights above a threshold (typically 10-15% of collateral value), application of proceeds (pay down debt or reinvest in similar collateral), and fair market value requirements. We've seen structures where borrowers could sell collateral to affiliates at self-determined "fair value"—that's a gap you can drive a truck through.
The covenant package only matters if it comes with meaningful remedies. We look for structures that give lenders options—not just the nuclear option of acceleration and foreclosure.
In specialty credit, intermediate remedies matter: increased reporting requirements, cash sweep provisions, restrictions on new spending, consent rights over major decisions. These tools let you tighten control when performance deteriorates without immediately triggering a default that might push the borrower into bankruptcy.
We also pay close attention to cross-default provisions. If the borrower has other institutional debt, you want to know about defaults elsewhere—and ideally have the option to declare your own default if senior lenders accelerate or if payment defaults occur on other obligations.
Finally, remember that information rights are protective even if they're not typically listed as "covenants." Monthly reporting on collateral performance, aging reports for receivables, quarterly audited financials, annual third-party appraisals—these aren't administrative requirements, they're early warning systems.
We've seen situations where problems were visible in weekly cash reports six months before they showed up in financial covenants. But only if you're receiving those reports in the first place, and only if someone is actually reading them.
Process note
We work with your counsel to review covenant packages before you commit capital. This isn't something to negotiate yourself. Specialty credit documentation requires attorneys who work in this specific area—not your corporate M&A lawyer, and not general banking counsel. Get the right specialist involved early.
These details matter more than most investors realize. The difference between recovering 85 cents on the dollar and taking a complete loss often traces back to covenant language that no one read carefully during diligence.