What it means
Lenders face a simple problem: once the cash is advanced, the borrower controls what happens next. Negative covenants close off the most damaging options, which is why they are sometimes called restrictive covenants.
The usual list is short and predictable. Borrowers agree not to incur additional debt beyond a stated level, not to grant security over assets to other lenders, not to sell or transfer material assets, not to pay dividends above a set amount, and not to change the nature of the business or its ownership without consent.
Many negative covenants are expressed as a test rather than a flat ban. A borrower may incur more debt provided the ratio of total debt to EBITDA, meaning earnings before interest, tax, depreciation and amortisation, stays below an agreed multiple after the new borrowing.
The practical consequence is that finance teams monitor headroom continuously. Every quarter they calculate the covenant ratios, model the next four quarters, and flag early if a fall in earnings could push a ratio through its limit, because a covenant breach can make the whole facility repayable on demand.
Breaches are usually negotiated rather than enforced literally. Lenders often grant a waiver or reset the level in exchange for a fee, a higher margin or tighter reporting, but the borrower's bargaining position at that moment is weak, which is exactly why headroom is watched so carefully.
In practice
Real-world examples.
Example
A mid-market manufacturer wants to buy a competitor for $12,000,000 using new debt, but its facility agreement caps leverage at 3.0 times. The finance director models the combined earnings, finds pro forma leverage of 3.4 times, and has to fund part of the price with equity instead.
Example
A family-owned distributor agrees a covenant limiting annual dividends to 50% of net profit while a term loan is outstanding. When the owners request a larger distribution after a strong year, the bank asks for a fee and a reduced loan balance in exchange for a one-off consent.
Example
A hotel group's bond documents prohibit the sale of any property representing more than 10% of group assets without noteholder approval. A planned disposal of its flagship site is restructured as a sale and leaseback with the proceeds applied to debt, so that the covenant is satisfied.
Formula
Calculation
A common test is: total debt / EBITDA must not exceed the agreed multiple. Maximum permitted debt = covenant multiple x EBITDA.
Suppose a packaging business has EBITDA of $20,000,000 and existing total debt of $45,000,000, with a negative covenant capping leverage at 3.0 times. Current leverage is $45,000,000 / $20,000,000 = 2.25 times, comfortably inside the limit.
Maximum permitted debt is 3.0 x $20,000,000 = $60,000,000, so the company has $60,000,000 - $45,000,000 = $15,000,000 of borrowing headroom. The trap is that the test also fails if earnings drop: if EBITDA fell to $14,000,000 with debt unchanged at $45,000,000, leverage would be $45,000,000 / $14,000,000 = 3.21 times and the covenant would be breached without a penny of new borrowing.Case study
Seen in the real world.
Brightfold Packaging Group is a fictional company used here as an illustrative example. Brightfold borrowed $45,000,000 to fund a new plant, with negative covenants capping leverage at 3.0 times EBITDA, restricting dividends and blocking any security given to other lenders.
Two customers cut their order volumes in the same quarter and EBITDA slipped from $20,000,000 to $15,500,000, taking leverage to about 2.9 times. That was still inside the limit, but the treasury team's rolling forecast showed a breach two quarters out if volumes did not recover, so they approached the bank early rather than waiting.
The bank agreed to reset the covenant to 3.5 times for four quarters in exchange for a 0.5 percentage point increase in the margin, monthly reporting and a pause on dividends. The illustrative point is that negative covenants rarely bite because of reckless borrowing; they bite because earnings fall while the debt stays exactly where it was.
Watch out
Common mistakes.
- Thinking covenants only matter if payments are missed. A negative covenant breach is an event of default in its own right, and the lender's rights are triggered even on a perfectly serviced loan.
- Reading only the headline ratio and ignoring the definitions. How the agreement defines debt and EBITDA, including add-backs and lease liabilities, often matters more than the number itself.
- Assuming a covenant applies only to the borrowing entity. Most agreements test the group on a consolidated basis, so a subsidiary's borrowing or asset sale can breach the parent's covenant.
Questions
People also ask.
What is the difference between a negative and an affirmative covenant?
A negative covenant says what the borrower must not do, while an affirmative covenant says what it must do, such as file accounts on time or maintain insurance.
What happens immediately after a breach?
Typically the lender can declare a default and demand repayment, but in practice most breaches are resolved through a waiver or an amendment carrying a fee and tighter terms.
Do bonds have negative covenants too?
Yes, though bond covenants are often looser than bank covenants and are tested only when the issuer takes a specific action, such as incurring debt or paying a dividend.
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