The short answer
A covenant is an ancillary condition in a loan agreement. It obliges the borrower to keep certain ratios within agreed limits and to report on them regularly. Breach a condition and a right of termination arises – regardless of whether every interest payment and instalment was made on time.
That is exactly what makes the subject uncomfortable: a company can be perfectly able to pay and still end up in default.
A note for readers outside Germany
Two features of German mid-market lending are worth knowing. An equity ratio covenant is still common here, which is unusual in Anglo-American documentation – and it is calculated on HGB accounts, not IFRS, so the ratio moves for reasons that have nothing to do with performance. And shareholder loans are frequently excluded from net debt where they are subordinated by a qualified subordination agreement under German insolvency law. Whether that agreement is worded correctly therefore changes the leverage ratio directly.
The typical ratios
- Leverage. Net debt divided by adjusted EBITDA. By far the most common ratio in private equity financings, usually with a limit that steps down over the term.
- Interest cover. EBITDA divided by interest expense. Since rates rose, the binding constraint again in many structures.
- Debt service cover (DSCR). Operating cash flow against interest and amortisation – widespread in classic bank financings and in real-estate-backed deals.
- Equity ratio. Still frequent in the German mid-market, often combined with a definition that treats shareholder loans as equity.
- Capex limit. Caps annual investment.
Alongside these sit the non-financial obligations: delivery of the annual accounts, monthly or quarterly figures, the plan, notification of changes in shareholdings or of litigation. They are often overlooked – and breaching one is just as much a breach as missing a ratio.
The definition matters more than the limit
Two loan agreements with an identical leverage limit can be entirely different in how tight they are, because the definitions differ. Four points decide it:
- What counts as net debt? Bank debt only, or also leases, factoring, pensions, shareholder loans?
- How is EBITDA defined? Which adjustments are permitted, is there a cap on them, and is the EBITDA of acquisitions included pro rata or for a full twelve months?
- Is it calculated on a rolling twelve months or on the financial year?
- On which dates is it tested? Usually quarterly, sometimes with different limits per quarter.
Anyone who has not once translated the definitions cleanly into a calculation rule is, in case of doubt, calculating differently from the lender – and finds out at the first dispute.
The compliance certificate
The formal evidence is a signed confirmation from management, usually within 30 to 45 days of quarter end. It contains the calculated ratios, their derivation from the accounts, and confirmation that no breach has occurred.
What works in practice is a fixed working file with three sheets: the calculation with a reference to the contractual clause, the reconciliation from the accounting system, and a trend view of the last eight quarters. That turns the certificate into an hour's work instead of two days – and the trend shows the direction before it becomes a problem.
Monitoring headroom
The most important figure appears in no agreement: the distance between the actual value and the limit. A traffic light in the monthly reporting with an internal warning threshold set well before the contractual limit works well – together with a projection across the next four test dates based on the current plan.
A breach typically creeps up. Rolling twelve-month EBITDA declines over three quarters while debt stays flat. Anyone calculating only the test date sees the breach in the quarter it happens. Anyone calculating the projection sees it two quarters earlier – and only then has any room to negotiate.
When a breach is coming
The order decides the outcome. First recalculate whether the breach will actually occur, including the adjustments the agreement permits. Then assess the options: a waiver gives up the legal consequence on a one-off basis, a reset adjusts the limits going forward, an equity cure allows the shareholders to repair the ratio arithmetically by injecting capital. The equity cure is standard in private equity structures, but limited in number and amount.
In every case the same rule applies: inform the lender early, with a 13-week cash forecast, an updated plan and a list of measures. A breach that is announced and explained is a negotiation. A breach the lender discovers alone is an escalation.
Frequently asked questions
What actually happens when a covenant is breached?
Legally, a right of termination arises. In practice a first breach that can be explained usually leads to a waiver – often against a fee, a margin increase or additional reporting obligations. It becomes critical on repetition or where transparency is missing.
How often is testing done?
Quarterly test dates with evidence within 30 to 45 days are common, plus an annual test based on the audited accounts. Some agreements require monthly reporting without a test.
Do shareholder loans count as debt?
That depends entirely on the definition in the agreement. They are often excluded where they are subordinated and cannot be serviced during the term. This clause should be checked before signing, because it changes the leverage ratio considerably.
Who should own covenant reporting?
The finance function prepares it, management signs it. What matters is that one person knows the contractual clauses, not only the ratios. In leveraged portfolio companies this is one of the interim CFO's core tasks in the first weeks.
Read on
- Covenant – definition and types in brief.
- The first 100 days after closing – where covenant reporting gets set up.
- Finance in a restructuring – when the breach has already happened.
- Interim CFO for private equity portfolios.
Sources and status
This article draws on nugrow's mandate practice in leveraged companies. Contractual clauses are individually negotiated; your own loan agreement always governs. As of September 2026. This article is an overview and does not replace legal advice.
