The covenant rarely stops a default. It puts the lender at the table early, and that is where the value is.
Price it as the present value of what the covenant gets the lender when the borrower weakens: the amendment fee and margin step-up on a breach, and a higher recovery if the borrower later defaults. On an illustrative five-year loan with a 20 per cent chance of a breach and an 8 per cent chance of default, a maintenance covenant is worth 1.29 points of the loan in present value, about 34 basis points a year, and 70 per cent of that comes from recovering 70 cents instead of 55, not from the fees.
Worked in full in The Private Credit Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A maintenance covenant is tested every quarter, whether or not the borrower does anything. A leverage test set with headroom over the base case will trip when earnings fall, long before the borrower runs out of cash. A covenant-lite loan has only incurrence tests, checked when the borrower takes an action such as raising more debt, so the lender's first contractual say often comes at a missed payment.
The covenant does not stop a borrower from failing. What it buys is time and leverage in the negotiation. When the test is breached, the borrower needs a waiver, and the lender can charge for it: a fee, a higher margin, a paydown, more reporting, or an equity cure from the sponsor. If the business keeps deteriorating, the lender is already at the table a year or more before a payment default, and can push for a sale or restructuring while there is more value left. Those two benefits are what a direct lender is pricing when it argues that its covenants justify a wider spread than a covenant-lite loan.
| Input | Value |
|---|---|
| Probability the leverage covenant is breached, in year 2 | 20% |
| Probability a breached borrower goes on to default, in year 3 | 40% |
| Probability of default over the life | 8% |
| Amendment fee on the breach, points | 0.50 |
| Margin step-up after the amendment | 100 bp |
| Recovery with a maintenance covenant, cents | 70 |
| Recovery covenant-lite, cents | 55 |
| Discount rate | 10% |
The default probability is the same in both structures. That is deliberate: the covenant is assumed to change what the lender gets out of a failing borrower, not whether the borrower fails. Any reduction in defaults would add to the value.
PV of the amendment fee = P(breach) × fee × DF(year 2)
PV of the step-up = P(breach) × [ P(survive) × step-up × DF(years 3 to 5) + P(default) × step-up × DF(year 3) ]
PV of the recovery uplift = P(breach) × P(default | breach) × (70 − 55) × DF(year 3)
Spread equivalent = total PV ÷ five-year annuity factor (3.791 at 10%)
Excel: =PV_total/PV(10%,5,-1)
| Component | Present value, points | Basis points a year |
|---|---|---|
| Amendment fee | 0.083 | 2.2 |
| Margin step-up, borrowers that recover | 0.247 | |
| Margin step-up, borrowers that later default | 0.060 | |
| Amendment economics, subtotal | 10 | |
| Higher recovery on default | 0.902 | 24 |
| Total | 1.291 | 34 |
The step-up only runs for the years the borrower is still paying: three years for the 12 per cent of borrowers that breach and recover, one year for the 8 per cent that breach and then default. The spread equivalent divides by a full five-year annuity and ignores prepayment, so it is a convenient yardstick rather than an exact yield.
The covenant is worth 1.29 points of present value, or 3.23 million on a 250 million loan. As a spread it is about 34 basis points a year. Undiscounted, the expected loss over the life falls from 3.60 points covenant-lite to 2.40 with the covenant, because loss given default drops from 45 to 30 per cent. That loss reduction is the heart of the value: the recovery line alone is worth 24 of the 34 basis points.
| Recovery uplift, cents | Breach waived for a fee and step-up | Breach waived free |
|---|---|---|
| 0 | 10 | 0 |
| 5 | 18 | 8 |
| 10 | 26 | 16 |
| 15 | 34 | 24 |
| 20 | 42 | 32 |
The value scales almost in line with the chance of a breach: 17 basis points at a 10 per cent breach probability, 34 at 20 and 51 at 30. A covenant set too loose to trip before the borrower is in real trouble moves the loan towards the top of the right-hand column: no amendment economics and little recovery uplift, because by the time it trips the value has already gone. Headroom matters as much as the presence of the test, which is why how much room a thin downside actually leaves is worth computing on every deal.
Valuing the covenant by the fees it generates. A 0.50 point waiver fee on a 20 per cent chance of breach is worth 2.2 basis points a year, which makes covenants look like an administrative nicety a lender can trade away for a few basis points of spread. The step-up adds a little more. The real value is in the default path, which no fee schedule shows: an earlier seat at the table, while the sponsor still has a reason to inject equity and the business still has a value worth protecting.
The recovery uplift is the least observable input and the one the answer depends on. Treat 15 cents as an assumption to test against your own workout history, not as a market fact. If your team does not use the breach to act, the covenant is worth the top row of the table at best.
The book's lender model, with its base, downside and stress cases and the covenants tested in each, is in the free workbooks for this book. The related question of what one point of fixed charge cover is made of is worked in how to calculate a fixed charge coverage ratio.
A maintenance covenant is tested every quarter whatever the borrower does, so falling earnings alone can breach it. An incurrence covenant is only tested when the borrower takes an action, such as raising debt. In the illustration the maintenance test gives the lender a breach in year 2 with 20 per cent probability, a year before the 8 per cent of borrowers that default stop paying.
Not necessarily, and the illustration assumes they do not. Their main effect is on loss given default: intervening early, the lender recovers an assumed 70 cents instead of 55, which cuts expected loss over the life from 3.60 to 2.40 points. Any reduction in default rates would be on top of that.
It depends on breach probability, headroom and recovery uplift. On the illustrative inputs it is about 34 basis points a year: 10 from amendment fees and step-ups, 24 from better recovery. With no recovery uplift it falls to 10, and if breaches are waived free it falls to 0. With a 20 cent uplift and priced waivers it rises to 42.
This article is one calculation from The Private Credit Investor. 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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