Maintenance covenants remain the norm in private credit agreements, but their effectiveness has deteriorated as ratio test headroom has widened.   Financial maintenance covenants are essential for lenders in the middle market, where borrowers tend be small or medium enterprises that are highly leveraged and generally more vulnerable to economic stress. Compared to the world of broadly syndicated loans (BSL), where around 90% of loans lack maintenance covenants that are tested on a regular basis, most direct loans to middle-market companies have at least one maintenance covenant. These are typically leverage ratio tests that measure a company's ability to service debt by comparing total debt to EBITDA. If the covenant is breached, it could constitute an immediate event of default for a borrower if it has not addressed the situation with its lender(s).

Thus, maintenance covenants allow lenders to monitor a borrower's financial health over time and serve as an early warning indicator when the company's operating performance begins to worsen. Most importantly, maintenance covenants serve as a risk management tool for lenders, giving them the right to intervene and renegotiate terms or take other corrective actions if a company is in distress.

However, competition between the BSL and private debt markets amid a subdued merger and acquisition backdrop has led to weakening documentation in the upper-middle market (see Systemic Risk: Private Credit’s Characteristics Can Both Exacerbate And Mitigate Challenges Amid Market Evolution, published Feb. 18, 2025, on RatingsDirect), with an increasing share of larger private debt issuances of over $500 million being structured without maintenance covenants as direct lenders have relaxed certain requirements to keep capital deployed. We've also recently seen maintenance covenants get amended away for some borrowers in the core middle-market segment. Such "covenant-lite" arrangements have mostly been confined to larger capital structures.

However, broader elements of covenant and credit risk lurk in borrower-friendly loans that were originated with loose maintenance covenants or subsequently amended to set a maximum leverage threshold particularly wide relative to the company's actual metrics at the time (not to mention that EBITDA calculations for covenant compliance purposes usually include various add-backs that can obfuscate a borrower's true earnings power).

To put this all in perspective, a leveraged buyout transaction with debt to EBITDA of 5x at closing may have a maximum total leverage ratio threshold of about 8.25x as a maintenance covenant that will be tested on a quarterly basis. This could qualify as a "covenant-loose" deal because the wide ratio headroom of nearly 40% effectively allows for significant erosion in operating performance to the point where EBITDA has declined by an equivalent percentage before the covenant is tripped and the lender can enforce its rights. It can also open the door for a borrower to incur incremental debt, though its ability to do so may be constrained by incurrence covenants that are only triggered upon specific actions and are not tested regularly like maintenance covenants.

We've identified numerous credit-estimated borrowers across all segments of the middle market that currently have generous headroom of 40% and above on their leverage-based maintenance covenants. We note this could partially be a function of some borrowers growing EBITDA, amending their credit agreements, and/or paring down debt post-origination, though a minority of credit-estimated companies in this subset were proven to reduce leverage based on a comparison of debt to EBITDA metrics in current and prior compliance certificates. Our analysis also omits covenant step-down or step-up features, which are less common across our credit estimates portfolio.

More than a third of middle-market borrowers subject to leverage-based maintenance covenants appear to have covenant-loose debt, with even higher proportions in the core and upper segments of the market.  

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Based on our analysis of more than 2,000 credit-estimated borrowers with actively tested debt to EBITDA-based maintenance covenants, we found that over a third of them had covenant headroom exceeding 40% when comparing the maximum test threshold to the actual ratio calculated in their compliance certificates at the time of the latest review. The distribution of companies with wide covenants was significantly higher in the upper (52%) and core (44%) segments than the lower-middle market (29%).

We also noticed that relatively few companies were subject to more than one maintenance covenant. As expected, lower-middle market borrowers were more likely to have other financial covenants, such as a minimum fixed-charge coverage ratio test in addition to the standard leverage test, and about 35% of these companies were required to comply with multiple maintenance tests versus about 20% of firms in the core and upper segments. Specific to covenant-loose deals across segments, the figure was only 19%, suggesting that most of these loans lack this extra feature.

At an absolute level, leverage covenant ceilings at or above 8x were much more widespread outside of the lower middle market, representing roughly 40% in core and over 50% in the upper segment, which is unsurprising given that buyout multiples tend to be higher upmarket.

Looser maintenance covenants could ultimately impair recovery values, similar to the effect of covenant-lite terms.   Wide covenant headroom can be a double-edged sword. On one hand, it is a boon to borrower liquidity (there is less likelihood of losing access to revolving credit facilities or prompting other restrictions), but it can also be detrimental to lenders. In a prior study on defaulted covenant-lite syndicated loans, we found that on average, realized recoveries tend to be about 11% lower compared to first-lien loans that did have maintenance covenants in place (see Settling For Less: Covenant-Lite Loans Have Lower Recoveries, Higher Event And Pricing Risks, published Oct. 13, 2020, on RatingsDirect). Although the study was not oriented to private debt or loose maintenance covenants, the dynamic is analogous--wider covenants inhibit a lender's ability to take remedial actions in the early stages of borrower stress. With a covenant-loose format, lenders must wait longer before unilaterally bringing a borrower to the bargaining table.

Often, a lender might negotiate modified terms on the loan, aiming to reduce potential loss exposure (via supplementary covenants, higher interest margins, additional collateral, or increased debt amortization) or to limit further credit deterioration by restraining capital expenditure, revolver availability, or the ability to pay dividends. In more severe cases, a lender's ability to call a default and accelerate loan repayment would also be delayed. As a result, the borrower's enterprise value might erode to a point where recoveries are negatively impacted if the company ultimately defaults.