Covenant

What Is a Covenant?

A covenant is a contractual obligation embedded in a financing agreement, bond indenture, or acquisition document that either requires a party to take specific actions (affirmative covenant) or prohibits certain activities (negative covenant) (Investopedia). In the M&A context, covenants appear in both the debt agreements that finance acquisitions and in the sale and purchase agreement that governs the transaction itself.

Covenants protect lenders and counterparties by establishing guardrails around the borrower’s or target’s behaviour, ensuring the business operates within agreed parameters.

Types of Covenants

Affirmative Covenants

Affirmative covenants require the borrower to take specific actions:

• Financial reporting — deliver quarterly and annual financial statements by specified deadlines
• Insurance — maintain adequate insurance coverage on business assets
• Tax compliance — pay all taxes when due
• Legal compliance — comply with applicable laws and regulations
• Asset maintenance — keep assets in good working condition
• Notification — promptly inform the lender of material events (defaults, litigation, material adverse changes)

Negative Covenants

Negative covenants restrict the borrower from taking specified actions without lender consent:

• Debt limitations — cannot incur additional debt above a threshold
• Lien restrictions — cannot pledge assets as collateral for other obligations
• Dividend restrictions — cannot pay dividends or make distributions above specified amounts
• Asset sales — cannot sell material assets without lender approval
• M&A restrictions — cannot make acquisitions or merge with another company without consent
• Change of control — the loan may accelerate if a change of ownership occurs

Financial Covenants

Financial covenants require the borrower to maintain specified financial ratios:

Covenant	Typical Threshold	Purpose
Leverage ratio (Debt/EBITDA)	≤ 4.0–6.0x	Limits total debt relative to earnings
Interest coverage	≥ 2.0–3.0x	Ensures earnings can cover interest payments
Fixed charge coverage	≥ 1.1–1.5x	Ensures cash flow covers all fixed obligations
Minimum liquidity	Varies	Maintains a cash or availability buffer
Capex limits	Varies	Controls capital spending

Maintenance vs Incurrence Covenants

Type	Testing	Common In
Maintenance	Tested regularly (quarterly) regardless of borrower action	Bank loans, term loans
Incurrence	Tested only when the borrower takes a specific action (e.g., incurring new debt)	High-yield bonds, covenant-lite loans

The trend toward “covenant-lite” (cov-lite) loans — which use incurrence covenants rather than maintenance covenants — has given borrowers greater flexibility but reduced lender protections.

Covenants in M&A Transactions

SPA Operating Covenants

Between signing and closing, the SPA typically requires the seller to operate the business in the “ordinary course” and restricts actions such as:

• Hiring or terminating senior employees
• Entering into material contracts
• Making capital expenditures above a threshold
• Changing accounting policies
• Declaring dividends or making distributions

Acquisition Financing Covenants

The debt used to finance an acquisition comes with its own covenant package. In a leveraged buyout, covenant negotiations between the sponsor and lenders are critical — overly restrictive covenants limit the sponsor’s ability to execute value creation plans, while overly permissive covenants increase lender risk.

Covenant Breach and Remedies

When a covenant is breached:

• Waiver — the lender may agree to waive the breach, often in exchange for a fee or tighter terms
• Amendment — the covenant may be permanently modified to reflect the new reality
• Default — if not waived, the breach constitutes an event of default, potentially accelerating all outstanding debt
• Cure period — some covenants include a grace period allowing the borrower to cure the breach before it becomes a default
• Equity cure — some agreements allow the sponsor to inject equity to bring financial ratios back into compliance

Covenants in Asia Pacific

Covenant structures in Asia Pacific financing markets reflect regional lending practices and regulatory frameworks. In Australia, leveraged acquisition financing typically includes maintenance covenants with quarterly testing, though cov-lite structures are becoming more common for larger transactions. In Japan, bank-dominated lending markets tend to use relationship-based covenant structures with greater informal flexibility. In Southeast Asia, covenant packages vary significantly by market — Singapore-based lending follows international standards, while local currency financing in emerging markets may have different covenant frameworks. AI-native platforms like Amafi help dealmakers benchmark covenant packages and negotiate financing terms across Asia Pacific jurisdictions.