Counted usage, the threshold, the letter of credit carve-out and the quarter-end repayment, worked over four quarters of a covenant-lite facility.
A springing covenant is a financial covenant that is tested only when revolver usage at the test date exceeds a threshold, typically a percentage of commitments. On an illustrative €75.0m revolver with a 40 per cent trigger, a €10.0m letter of credit carve-out and a 7.00x net leverage test, the borrower is tested in two of four quarters and breaches in the fourth at 7.33x. Repaying €17.0m of revolver from cash on the last day switches the test off, with leverage unchanged.
Worked in full in How to Read a Credit Agreement by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
In a typical covenant-lite structure the term loan carries no maintenance covenant. The revolving facility carries one financial covenant, for the benefit of the revolving lenders only, which applies "if, on the last day of a test period, the aggregate of outstanding revolving loans and letters of credit (other than letters of credit up to the carve-out) exceeds 40 per cent of the total revolving commitments". Each word in that sentence is an input to a calculation.
| Term | Value |
|---|---|
| Revolving commitments | 75.0 |
| Springing threshold | 40% of commitments = 30.0 |
| Letters of credit excluded from usage | up to 10.0 |
| Covenant when sprung: net leverage, maximum | 7.00x |
| Term loan B, no maintenance covenant | 400.0 |
| Letters of credit outstanding, every quarter | 12.0 |
Counted usage = revolving loans + max(letters of credit − carve-out, 0)
Tested if counted usage / commitments > threshold
Excel: =IF((Loans+MAX(LCs-Carve,0))/Commit>Threshold,"tested","not tested")
With 12.0 of letters of credit and a 10.0 carve-out, only 2.0 of them count. The borrower can therefore draw 30.0 − 2.0 = 28.0 of cash loans and still not be tested.
| Quarter | RCF loans | Counted usage | Utilisation | Net debt | LTM EBITDA | Net leverage | Result |
|---|---|---|---|---|---|---|---|
| Q1 | 10.0 | 12.0 | 16.0% | 385.0 | 70.0 | 5.50x | Not tested |
| Q2 | 28.0 | 30.0 | 40.0% | 408.0 | 66.0 | 6.18x | Not tested |
| Q3 | 36.0 | 38.0 | 50.7% | 421.0 | 62.0 | 6.79x | Tested, passes |
| Q4 | 45.0 | 47.0 | 62.7% | 425.0 | 58.0 | 7.33x | Tested, breach |
Net debt is the 400.0 term loan plus revolving loans, less cash of 25.0, 20.0, 15.0 and 20.0 in the four quarters. Three points come out of the table.
The borrower has 20.0 of cash at Q4. If it repays 17.0 of revolving loans on the last day of the quarter, loans fall to 28.0, counted usage to 30.0, utilisation to 40.0 per cent, and the test does not apply. Net debt is still 425.0, because cash fell by the same 17.0, and net leverage is still 7.33x. The economic position has not moved; the covenant has stopped looking at it.
A springing test measures usage, not credit quality. A borrower with cash can usually choose whether it is tested, and the quarters in which it cannot are the quarters in which the cash has gone. The test therefore tends to bite late, when the revolver has been drawn to fund losses, which is exactly the point at which the revolving lenders most need it.
Agreements respond to this with drafting: testing on average daily usage over the quarter rather than the last day, a clean-down that cannot be redrawn within a set number of days, or netting cash against revolving loans for the trigger as well as the ratio. Each is a line to look for when reading the clause.
| Threshold | Trigger | No LC carve-out | 10.0 LC carve-out |
|---|---|---|---|
| 25% | 18.75 | 6.75 | 16.75 |
| 35% | 26.25 | 14.25 | 24.25 |
| 40% | 30.00 | 18.00 | 28.00 |
| 50% | 37.50 | 25.50 | 35.50 |
The letter of credit carve-out is worth 10.0 of untested drawing at every threshold. For a borrower whose letters of credit are operational, a performance bond or a lease guarantee, that is a sensible exclusion. For one that has been issuing letters of credit to replace cash collateral, it is a hole in the trigger.
Compute counted usage first, then the ratio. Here the test applies in Q3 and Q4, passes at 6.79x and breaches at 7.33x, and a 17.0 quarter-end repayment removes the breach without changing leverage. Headroom when the test does apply is calculated as in how to calculate covenant headroom, and why the undrawn revolver is not the liquidity it appears to be is in does an undrawn revolver count as liquidity. The covenant definitions, cure limits and test dates of a complete facility are inputs in the free workbook for the book's case.
Thresholds are negotiated, and illustratively sit somewhere between 25 and 40 per cent of revolving commitments. The level matters less than what counts towards it. On a €75.0m facility with €12.0m of letters of credit, a 40 per cent trigger allows €18.00m of cash drawings untested with no carve-out and €28.00m with a €10.0m carve-out.
Usually not. The covenant is typically for the benefit of the revolving lenders only, and a breach often triggers a term loan default only if the revolving lenders accelerate. In this case the term loan alone is 400.0 against 58.0 of EBITDA, 6.90x, and its lenders have no maintenance test of their own.
Often, if it has the cash and the agreement tests usage on the last day of the quarter. Here repaying €17.0m of revolving loans from €20.0m of cash takes usage to exactly 40.0 per cent, so the test does not spring, while net debt stays at €425.0m and net leverage at 7.33x.
This article is one calculation from How to Read a Credit Agreement. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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