Negative Covenants: The Silent, but Mighty, Guard Rails of Credit
In today’s highly competitive lending environment, covenants have become a battleground in structuring credit agreements. Covenants can offer significant protections to creditors, yet many of these contractual stipulations have been either watered down or outright omitted in leveraged buyouts over the past decade as lenders compete with one another to win deals. As a result, lenders have been faced with tough decisions over which provisions to hold their ground on when negotiating new loan documents.
The covenant tool kit is a wide one, and we think a successful lending strategy relies on correctly identifying the most important provisions and structuring them appropriately. We think negative covenants are one of the most important guardrails when it comes to ensuring alignment of interest between parties and protecting creditor value, but they are often overlooked in the current dealmaking environment.
What Are Covenants?
Covenants are not a new concept. The word “covenant” originates from the Latin “convenire”, the Old French “covernir,” and the English “convene,” and its definition is an “agreement, a pact, or a promise.” The contemporary meaning of the word in the context of credit markets is a formal promise or contract prescribing specific actions to be undertaken – or avoided – by borrowers. These clauses are critical in loan agreements, as they shape the relationship between debtor and creditor by setting actionable boundaries. A breach of a covenant generally tiggers an event of default, giving creditors certain rights, including the ability to accelerate their claims.
In loan documents, covenants can be classified into three broad types:
- Positive covenants: Actions borrowers must undertake under a loan agreement (i.e. providing financial statements or maintaining adequate insurance coverage). Information undertakings require borrowers to provide regular reporting on pre-defined elements such as financial performance. General undertakings ensure borrowers uphold basic principles, such as operating in compliance with applicable laws.
- Negative covenants: Restrictions on what borrowers can do under the governing loan agreement. These covenants prevent borrowers from weakening a creditor’s position, either by extracting value or by diluting creditors’ claims through the incurrence of additional liabilities. For example, under negative covenants, borrowers may be restricted from paying dividends or transferring assets outside of the borrowing group, to affiliates, without prior approval.
- Maintenance covenants : Periodic financial tests with which borrowers must comply, such as indebtedness ratios, interest coverage, or minimum liquidity requirements. These are often referred to as financial covenants.
Non-compliance with a covenant, subject to any agreed-upon grace periods, typically triggers an event of default. This may allow creditors to accelerate debt claims, making them immediately due and payable. In such scenarios, assuming they are not repaid in full, creditors may enforce their right to recover the amount owed, often by taking control of the borrower.
The Case for Negative Covenants
We think that a successful credit strategy is founded on selecting the right companies, which is why we lend to large, high-quality businesses with strong market share in defensive, non-cyclical sectors. Along with disciplined business selection, we believe that a robust set of negative covenants creates alignment between debt and equity holders and protect creditor interests.
Of the three types of covenants, maintenance covenants have historically been viewed as the strongest safeguard because they require borrowers to meet certain objective thresholds on an ongoing basis. However, overly flexible definitions in leverage ratios and financial thresholds, such as permissive EBITDA adjustments, can mask underperformance and make maintenance covenants less effective. As a result, non-performing borrowers often experience a liquidity event prior to breaching them.
Unlike maintenance covenants, positive and negative covenants create a set of rules that borrowers must follow. Positive covenants are a way to ensure a certain level of “good behavior,” such as complying with local laws, that serves to protect creditors’ capital. Negative covenants, however, aim to prevent behavior that may be harmful to creditors, and require a more expansive way of thinking.
Cases like that of the U.S. retail company J. Crew underscore the importance of getting negative covenants right. J. Crew was able to transfer material intellectual property (including the J. Crew brand and trademarks) outside the borrower group and use that intellectual property to raise more debt. The move stripped creditors of key assets, and the retailer filed for bankruptcy during the pandemic. Now, a negative covenant, informally called a “J. Crew blocker,” has been developed to prevent borrowers from taking similar actions in the future.
Other liability management exercises (e.g., Serta 1 , Chewy, Pluralsight) have showcased how loopholes in covenants allowed borrowers to dilute debt claims and extract value to the detriment of creditors. Such transactions highlight why watertight negative covenants are critical for protecting value and ensuring recovery in distressed situations.
Negative covenants can be considered successful when the sponsor or equity holder is unable to use the loan document itself to circumvent creditors’ claims. By firmly shutting down avenues for “bad behavior,” negative covenants force all stakeholders to the negotiating table and create opportunities for joint decision-making when a business defaults. This ensures that a business’ operations, as well as creditors’ security, is appropriately protected while performance issues are addressed. In other words, negative covenants prevent the divergence of stakeholder interests at the most critical points of a deal’s life.
In conclusion, negative covenants are not mere technicalities; they are the unsung pillars of robust lending and loan documentation practices. By effectively aligning the interests of all stakeholders, they act to safeguard creditor protections and preserve recovery value, especially in distressed situations. Well-structured negative covenants empower creditors to protect and enhance the integrity of their investments. As such, we believe they are indispensable tools in building resilient and successful credit strategies.
1. On December 31, 2024, the U.S. Court of Appeals for the Fifth Circuit invalidated Serta Simmons Bedding’s 2020 “uptier” debt restructuring, ruling it breached the company’s credit agreement by unfairly prioritizing certain lenders over others. This landmark decision challenges the legality of similar liability management exercises that have become prevalent among distressed companies.
Sources: Bloomberg Law, Reuters, Financial Times, S&P and Moody’s.
