Incurrence Covenant
An incurrence covenant is a credit-agreement restriction that is tested when a borrower proposes to take a specified action—such as incurring debt, making an investment, granting a lien or paying a restricted payment—rather than automatically on every recurring reporting date.
Incurrence tests are transaction-triggered
The covenant becomes relevant when the borrower wants to do something covered by the negative covenant.
This gives the borrower more operating flexibility than a maintenance covenant because poor performance alone does not necessarily create a default.
Ratio debt is a common example
Credit agreements can permit additional debt if the borrower satisfies a pro forma leverage ratio after giving effect to the new borrowing.
The test can vary depending on whether the new debt is first lien, junior lien or unsecured.
Fixed baskets provide capacity without a ratio test
Many negative covenants contain specific dollar baskets or EBITDA-based grower baskets.
That means a borrower may still incur debt or make an investment even when it cannot satisfy the broader ratio-based incurrence test.
Covenant-lite loans rely heavily on incurrence protection
Without a broad quarterly maintenance covenant, lenders rely more on negative covenants that restrict debt, liens, investments, asset sales and distributions when the borrower takes specified actions.
The borrower gains flexibility, while lenders have fewer automatic triggers during deterioration.
Incurrence capacity can remain large even when operating performance weakens
A borrower unable to satisfy a ratio-based debt test may still have fixed baskets, acquisition-specific baskets, free-and-clear capacity or debt permitted under another exception.
That is why analysts often build a debt-capacity bridge rather than reading one leverage covenant. The bridge identifies every source of permitted borrowing and then calculates how much remains available after existing usage.
The same approach applies to investments and restricted payments.
For lenders, broad incurrence capacity can allow additional claims or value transfers before a default occurs. For borrowers and sponsors, that flexibility can be valuable for acquisitions and liquidity management. The covenant’s practical strength therefore depends on the entire network of exceptions, not the general prohibition.
Common mistakes
Treating failure of an incurrence test as an existing default It usually blocks the proposed action instead.
Assuming ratio capacity is the only capacity Fixed and free-and-clear baskets can coexist.
Ignoring pro forma adjustments Acquisition EBITDA and debt repayment can change the test result.
Example
A borrower may incur unlimited ratio debt if pro forma first-lien leverage does not exceed 3.50×. If leverage is 4.00×, the borrower does not automatically default merely because of that ratio; instead, it cannot use that ratio-based debt capacity until the test is satisfied.
Example
A borrower may incur unlimited ratio debt if pro forma first-lien leverage does not exceed 3.50×. If leverage is 4.00×, the borrower does not automatically default merely because of that ratio; instead, it cannot use that ratio-based debt capacity until the test is satisfied.
Professional note
Identify what triggers the test and which alternative baskets exist. A borrower unable to satisfy a ratio test may still have fixed, grower, acquisition or free-and-clear capacity available.
Related terms
- Leveraged Loan
A leveraged loan is a corporate loan to a borrower whose leverage or credit profile places the financing within a lender’s or market participant’s leveraged-lending criteria, commonly in connection with buyouts, acquisitions, recapitalizations or highly leveraged companies.
- Covenant-Lite Loan
A covenant-lite loan is a loan that has fewer traditional financial maintenance covenants than a covenant-heavy loan, or no broadly applicable maintenance covenants, leaving lenders with fewer periodic financial tests that can trigger an early default.
- Financial Maintenance Covenant
A financial maintenance covenant is a credit-agreement requirement that a borrower satisfy a specified financial ratio or threshold on recurring test dates, such as quarter-end, regardless of whether the borrower is incurring new debt or taking another restricted action.
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