Incurrence covenants
LBOCovenants tested only when the borrower takes a specific action, such as raising more debt or paying a dividend.
An incurrence covenant is not tested on a schedule. It only applies when the borrower does something the document restricts: incurring additional debt, making a distribution, disposing of assets, or making an acquisition.
It is far more permissive than a maintenance covenant, because a company whose performance deteriorates without taking any restricted action never trips it. Lenders have no early trigger to renegotiate.
Covenant lite structures, which have become the norm in large leveraged loans, rely on incurrence testing alone. That shifts significant control from lenders to borrowers and sponsors, and is one reason recoveries in recent defaults have been lower.
The definitions do the work. What counts as EBITDA for the test, and how large the negotiated baskets and carve outs are, determine how much the borrower can actually do, which is why credit agreement drafting is fought over so hard.
Worked example
A credit agreement permits additional debt provided pro forma net leverage stays at or below 4.5x.
The borrower runs at 4.0x on 100 of EBITDA, so 400 of net debt. It wants 80 more to fund an acquisition bringing 15 of EBITDA.
Pro forma leverage is 480 over 115, which is 4.17x, inside the test, so the debt can be incurred with no lender consent. Had the acquisition brought no EBITDA, 480 over 100 is 4.8x and the test would block it.