Maintenance vs. Incurrence Covenants: The Difference Every IB Candidate Should Know

If you're prepping for leveraged finance, restructuring, or sponsor-heavy groups, there's a good chance you'll be asked: "What's the difference between maintenance and incurrence covenants?"

Here's the short answer. Maintenance covenants are tested regularly (usually every quarter) no matter what the company does. Incurrence covenants are tested only when the company tries to take a specific action, like borrowing more money or paying a dividend.

That one sentence gets you through the first follow-up. The rest of this post gets you through the next three, with numbers you can actually walk an interviewer through.

First, What Is a Covenant?

A covenant is a promise the borrower makes to its lenders in the credit agreement or bond indenture. It's the lender's way of saying, "We'll give you this money, but you have to stay within these guardrails."

Covenants come in a few flavors:

• Affirmative covenants: things the company must do (deliver financial statements, pay taxes, maintain insurance)
• Negative covenants: things the company can't do, or can only do within limits (take on more debt, sell assets, pay dividends)
• Financial covenants: ratio-based tests, like leverage or interest coverage

The maintenance vs. incurrence distinction is really about how and when those tests get applied.

Maintenance Covenants: The Quarterly Checkup

How they work

A maintenance covenant requires the company to stay within a financial ratio at every testing date, typically the end of each fiscal quarter. It doesn't matter whether the company did anything new. If the numbers slip past the limit, it's in breach.

Think of it like a doctor's checkup you can't skip. Even if you didn't change anything about your lifestyle, if your blood pressure is too high on the day of the test, you've got a problem.

Common examples

• Maximum total leverage: Total Debt / EBITDA must stay at or below, say, 5.0x
• Minimum interest coverage: EBITDA / Interest Expense must stay at or above, say, 2.5x
• Minimum fixed charge coverage: a broader version that also counts things like capex, taxes, or scheduled principal
• Minimum liquidity: cash plus revolver availability above a set dollar amount

Where you'll see them

Maintenance covenants are most common in:

• Revolving credit facilities
• Term Loan A (amortizing bank loans)
• Private credit / direct lending deals

The common thread? These loans are usually held by a relatively small group of lenders who are close to the borrower and want an early warning system.

Incurrence Covenants: Only Tested When You Act

How they work

An incurrence covenant only kicks in when the company wants to do something covered by the covenant. If the company just sits there, even through a terrible year, the covenant never gets tested.

Back to the analogy: this is less like a checkup and more like a bouncer. Nobody checks your ID while you're standing on the sidewalk. You only get checked when you try to walk into the club.

Common examples

• Debt incurrence test: the company can take on new debt only if, pro forma for that new debt, its fixed charge coverage stays above a threshold (2.0x is a common figure in high-yield bonds) or its leverage stays below a set level
• Restricted payments: limits on dividends, share buybacks, and certain investments
• Asset sales: rules about what happens to proceeds when assets are sold
• Liens: limits on pledging assets as collateral to other creditors

Where you'll see them

Incurrence covenants dominate in:

• High-yield bonds
• Covenant-lite term loans (most institutional Term Loan B deals)

The Worked Example: Same Company, Two Covenant Packages

Let's make this concrete. Meet WidgetCo:

• Total debt: $400 million
• LTM EBITDA: $100 million
• Leverage: $400m / $100m = 4.0x

Scenario 1: WidgetCo has a maintenance covenant

The credit agreement says leverage must stay at or below 5.0x, tested quarterly.

First, figure out the cushion. How far can EBITDA fall before WidgetCo breaches?

• Breach EBITDA = $400m / 5.0x = $80 million
• Cushion = ($100m − $80m) / $100m = 20%

Now a recession hits and LTM EBITDA drops to $75 million. WidgetCo didn't borrow a dollar more.

• New leverage = $400m / $75m = 5.33x
• That's above 5.0x, so WidgetCo is in breach

WidgetCo now has to call its lenders. That usually means negotiating a waiver or amendment, which often comes with an amendment fee, a higher interest rate, and tighter terms going forward.

Scenario 2: WidgetCo has only an incurrence covenant

Now say WidgetCo's debt is a high-yield bond with an incurrence test: the company can only take on new ratio debt if pro forma leverage stays at or below 4.75x.

Same recession, same $75 million of EBITDA, same 5.33x leverage. What happens? Nothing. No default, no phone call to lenders. WidgetCo just keeps paying interest.

The covenant only matters if WidgetCo wants to do something. Let's test it:

WidgetCo wants to borrow an extra $50 million.

• When EBITDA was $100m: pro forma leverage = $450m / $100m = 4.5x. Below 4.75x, so allowed.
• When EBITDA is $75m: pro forma leverage = $450m / $75m = 6.0x. Above 4.75x, so blocked.

Notice the difference. Being blocked from borrowing isn't a default. WidgetCo simply can't use that path to take on more debt (though in real deals it may still have carve-outs, or "baskets," that allow certain amounts of debt regardless of the ratio).

Side-by-Side Comparison

Why Do Different Instruments Use Different Covenants?

This is the "why" question that separates prepared candidates from memorizers.

It comes down to who holds the debt and how easy it is to renegotiate.

• Bank loans and private credit are held by a handful of lenders. If the company trips a covenant, getting everyone in a room to sign an amendment is very doable. So lenders can afford tight, frequently tested covenants.
• High-yield bonds are held by many investors who trade them around. Getting consent from a large, scattered bondholder base is slow and expensive. Tight maintenance covenants would cause constant, painful renegotiations, so bonds rely on incurrence tests instead.

There's also a pricing trade-off. Bonds typically pay higher interest rates, and part of what investors get paid for is accepting looser protections.

Two Concepts That Come Up Next

Covenant-lite loans and springing covenants

Cov-lite loans are term loans that have no financial maintenance covenants, just incurrence-style protections like a bond. They've become standard in the broadly syndicated leveraged loan market.

But here's the nuance: the revolver in a cov-lite deal often still has a springing maintenance covenant. It's only tested when the revolver is drawn above a certain level (thresholds like 35% or 40% of commitments are common). If the company isn't leaning on the revolver, the covenant stays dormant.

Equity cures

Many sponsor-backed credit agreements include an equity cure. If the company is about to breach a maintenance covenant, the private equity sponsor can inject equity, which gets treated as extra EBITDA (or applied to reduce debt) for the covenant calculation.

Lenders usually limit how often this can happen, for example restricting the number of cures within any four consecutive quarters and over the life of the loan.

Quick math using WidgetCo: to get back to 5.0x with $400m of debt, EBITDA needs to be $80m. With actual EBITDA at $75m, the sponsor would need to contribute about $5 million of cure equity counted toward EBITDA.

How to Answer This in an Interview

If you get the question, aim for something like this:

"Maintenance covenants require the company to stay within certain financial ratios at regular testing dates, usually quarterly, regardless of what it does. Incurrence covenants are only tested when the company takes a specific action, like issuing more debt or paying a dividend. Maintenance covenants are typical in bank loans and private credit because the lender group is small and can renegotiate easily. Incurrence covenants are typical in high-yield bonds and cov-lite term loans, where the holder base is large and amendments are harder, so they give the borrower more flexibility."

Then be ready for follow-ups:

• "Which is more borrower-friendly?" Incurrence. Poor performance alone can't trigger a default.
• "What happens if a maintenance covenant is breached?" It can become an event of default, which typically leads to a waiver or amendment, often with fees and a higher spread. An equity cure may be available.
• "What's cov-lite?" A term loan without financial maintenance covenants, often paired with a revolver that has a springing covenant.
• "How would you check covenants in an LBO model?" Calculate the relevant ratios each period, compare them to the covenant levels, and look at the cushion, especially in a downside case.

The Bottom Line

Here's the one idea to lock in: maintenance covenants watch the company all the time, incurrence covenants only watch the company when it acts.

Everything else, from why bonds look different from bank loans to why sponsors love cov-lite deals, flows from that distinction. Practice the WidgetCo math once or twice out loud, and you'll be able to handle this topic with confidence instead of reciting a definition.