Loan Covenants: The Fine Print That Can Force a Default Without a Missed Payment
Most borrowers focus on rate, term, and amortization when comparing loan offers. Covenants get less attention and create more problems. A covenant is a promise the borrower makes that lasts the life of the loan. Break one and the lender has the right to call the loan, even if every payment has been on time. Understanding the covenant landscape before you sign matters as much as understanding the interest rate.
Financial vs Affirmative vs Negative Covenants
Financial covenants set ongoing performance tests, usually measured quarterly or annually. Affirmative covenants require the borrower to do things (deliver financials, maintain insurance, pay taxes). Negative covenants restrict the borrower from doing things (taking on additional debt, paying distributions, selling assets). Each category creates a different category of default risk.
The Most Common Financial Covenants
Three show up on most commercial deals: (1) a minimum debt service coverage ratio, often 1.20x or 1.25x, tested annually; (2) a maximum loan-to-value or loan-to-cost ratio; (3) a minimum tangible net worth or liquidity floor for guarantors. CRE deals add property-level tests; operating-company loans add EBITDA-based leverage and fixed-charge coverage.
The Quiet Killers: Cross-Default and Material Adverse Change
Two clauses cause more accidental defaults than the financial covenants: cross-default, which says a default on any other loan triggers a default on this one, and material adverse change (MAC), which lets the lender call the loan if anything material changes in the borrower business or financial condition. MAC clauses are deliberately vague and almost impossible to negotiate out entirely, but their scope is negotiable.
How to Negotiate Covenants Before You Sign
Push back on cushion. A DSCR test at 1.25x is much tighter than 1.20x; a tangible net worth covenant at 2x current is much tighter than 1.5x. Ask for cure rights (typically 30 to 60 days to fix a breach), equity cure mechanics (allowing a capital injection to count toward the covenant), and reasonable carveouts to negative covenants for ordinary-course transactions.
What Happens When You Trip One
Defaulting on a covenant is not the same as missing a payment. Most lenders will not call the loan immediately; they will issue a notice of default and ask for a forbearance fee, a covenant waiver, or amended terms. The lender always has more leverage during a workout than they had during the original closing. The best protection is structuring the covenant package conservatively at the start.
Educational content only, not advice. KQT Advisors, LLC is a commercial loan broker; we are not a lender, attorney, accountant, financial advisor, or fiduciary. We do not originate loans or make lending decisions. The information in this article is provided strictly for general informational and educational purposes and reflects our understanding at the time of writing. It is not, and must not be construed as, financial, tax, legal, accounting, investment, or any other professional advice, and creates no advisor-client relationship. Loan programs, rates, terms, eligibility requirements, fees, and approval criteria are set by individual lenders, the SBA, and other parties and are subject to change at any time without notice. Examples are illustrative only and not guarantees of outcome. Nothing here is a commitment to lend, an offer of credit, or a representation that any specific structure will be available to or appropriate for any borrower. Always consult your own qualified financial, tax, and legal advisors before acting on any information in this article. To the maximum extent permitted by law, KQT Advisors, LLC and its principals, employees, agents, and affiliates disclaim all liability for any direct, indirect, consequential, or incidental loss or damage arising out of any use of, reliance on, or inability to use the information in this article.