Covenant Analysis: IG vs. HY

Step 1: Consolidated EBITDA

Start by checking whether the claimed cost savings fit inside the documented cap, then build the covenant definition of EBITDA.

Consolidated EBITDA = €180.0m + €12.0m + €8.0m = €200.0m

Cap test: 10% × €200.0m = €20.0m. The €8.0m of claimed run-rate savings sits comfortably below the €20.0m cap, so the full amount is permitted.

Consolidated EBITDA is not the same number the company reports to the market — it is a defined term in the credit agreement and the indenture, and every covenant in the package is calculated off it. That is why the add-back definitions are among the most heavily negotiated provisions in leveraged finance: each euro of permitted add-back mechanically lowers every leverage ratio and raises every coverage ratio. A generous cap on run-rate synergies (often 20-25% of EBITDA in aggressive deals, sometimes uncapped and with no time limit on realisation) can create several turns of phantom headroom, which is exactly why credit analysts rebuild the number from reported figures before trusting a covenant calculation.

Step 2: Consolidated Net Leverage Ratio

Total Debt = €450.0m + €250.0m = €700.0m

Net Debt = €700.0m − €60.0m = €640.0m

Consolidated Net Leverage Ratio = €640.0m / €200.0m = 3.20x

Test against the 3.50x maintenance covenant: 3.20x < 3.50x, so the issuer passes.

Headroom expressed as debt capacity: maximum permitted net debt = 3.50 × €200.0m = €700.0m, against actual net debt of €640.0m, giving €60.0m of absolute headroom.

Headroom expressed in earnings: the minimum Consolidated EBITDA that keeps the ratio at 3.50x is €640.0m / 3.50 = €182.9m. Relative to €200.0m that is a permitted decline of (€200.0m − €182.9m) / €200.0m = 8.6%.

The Consolidated Net Leverage Ratio is the single most watched maintenance covenant in the loan market because it tests the whole capital structure against the whole earnings base every quarter, regardless of whether the borrower does anything at all. The earnings framing matters more than the debt framing in practice: lenders and rating agencies care that a mid-single-digit decline in EBITDA is enough to trip this issuer, because that is well inside the range of a normal cyclical downturn for an industrials business. Under 10% of headroom is the level at which lenders typically start pre-negotiating amendments rather than waiting for the test date.

Step 3: Interest Coverage Ratio

Using the two coupons and the drawn amounts:

Total Cash Interest Expense = (€450.0m × 4.0%) + (€250.0m × 6.0%) = €18.0m + €15.0m = €33.0m

Interest Coverage Ratio = €200.0m / €33.0m = 6.06x

Test against the 3.00x maintenance covenant: 6.06x > 3.00x, so the issuer passes with wide margin.

The Interest Coverage Ratio asks a different question from leverage: not "how much debt is there" but "can the earnings service it in cash this year". The two ratios can point in opposite directions, and which one binds first tells you what kind of risk the structure carries. Here leverage binds long before coverage, which is the classic profile of a low-coupon, pre-rate-hike capital structure. If the term loan were floating rate and base rates rose 300bps, cash interest would climb to roughly €46.5m and coverage would fall to about 4.3x — still passing, but the gap between the two tests would narrow sharply. That sensitivity is why coverage covenants became the binding constraint across large parts of the leveraged loan market once rates moved.

Step 4: Incremental Debt Capacity Under the Incurrence Tests

Incurrence covenants are only tested when the issuer takes an action, so here we solve each test for the largest new debt amount that still satisfies it.

Test A — Fixed Charge Coverage Ratio (ratio debt test). Where: X = new debt raised, the new coupon is 7.0%, and existing cash interest is €33.0m.

€200.0m / (€33.0m + 0.070 × X) ≥ 2.00

€33.0m + 0.070 × X ≤ €200.0m / 2.00 = €100.0m

0.070 × X ≤ €67.0m → X ≤ €957.1m

Test B — Consolidated Secured Net Leverage Ratio (secured debt test). Where: S = new secured debt, existing secured debt is the €450.0m term loan, and cash is unchanged at €60.0m.

(€450.0m + S − €60.0m) / €200.0m ≤ 3.00

€390.0m + S ≤ €600.0m → S ≤ €210.0m

The binding constraint is the lower of the two: €210.0m of incremental secured debt.

The lesson here is that a covenant package is never a single number — it is a stack of tests, and the answer to "how much can we borrow" is always the minimum across the stack. The Fixed Charge Coverage Ratio is a flow test and is easy to satisfy when coupons are low relative to earnings, which is why it almost never binds in a healthy issuer. The secured debt test is a stock test and exists specifically to protect the unsecured noteholders from being structurally subordinated by a wave of new secured borrowing ahead of them in the waterfall. Interviewers use this exact setup to see whether a candidate solves both tests or stops at the first one that looks satisfied.

Step 5: Restricted Payments Capacity

First check the condition: the builder basket may only be used if the Fixed Charge Coverage Ratio test is met, and from Step 4 the ratio stands at €200.0m / €33.0m = 6.06x, comfortably above 2.00x. The basket is therefore available.

Cumulative Consolidated Net Income since the issue date = €24.0m + €30.0m + €36.0m = €90.0m

Builder basket = 50% (0.50) × €90.0m = €45.0m

Available RP Capacity = €45.0m + €25.0m − €18.0m = €52.0m

Restricted payments are the covenant category that governs cash leaving the credit group — dividends to the sponsor, share buybacks, and voluntary payments on junior debt. The builder basket is the elegant part of the design: it grows only as the issuer actually earns money, so the sponsor's ability to take cash out is tied to performance rather than granted upfront. The starter basket exists to give day-one flexibility before any income has accumulated. In practice this calculation is the first thing a credit analyst runs when a sponsor is rumoured to be planning a dividend recapitalisation, because it sets a hard ceiling on how much can be extracted without a consent solicitation or a new financing.

Step 6: Equity Cure Requirement in the Downside Case

Downside Consolidated EBITDA = €200.0m × (1 − 0.20) = €160.0m

Consolidated Net Leverage Ratio = €640.0m / €160.0m = 4.00x, against a covenant of 3.50x — a breach.

Mechanic A — EBITDA cure. The equity injection is deemed an addition to Consolidated EBITDA for covenant purposes.

Minimum Consolidated EBITDA required = €640.0m / 3.50 = €182.9m

EBITDA Cure Amount = €182.9m − €160.0m = €22.9m

Mechanic B — debt paydown cure. The equity injection must be applied to reduce debt instead.

Maximum permitted net debt = 3.50 × €160.0m = €560.0m

Debt Paydown Cure Amount = €640.0m − €560.0m = €80.0m

An equity cure is the sponsor's right — not obligation — to inject fresh equity and deem a covenant breach never to have occurred. The €57.1m gap between the two mechanics is the entire negotiation: because leverage is a ratio, curing through the denominator is roughly 3.5x more capital-efficient than curing through the numerator, and the multiple is exactly the covenant level itself. Sponsors push hard for the EBITDA cure and for the cured amount to roll forward into subsequent test periods; lenders push for debt paydown, for caps on the number of cures (typically no more than two in any four consecutive quarters and five over the life of the facility), and for no over-curing beyond the minimum needed to pass. Whether a package permits an EBITDA cure is one of the fastest ways to gauge how borrower-friendly the documentation is.

Final Results

• Consolidated EBITDA: €200.0m
• Consolidated Net Leverage Ratio: 3.20x vs. 3.50x maintenance covenant — pass, with €60.0m of debt headroom or an 8.6% EBITDA cushion
• Interest Coverage Ratio: 6.06x vs. 3.00x maintenance covenant — pass
• Incremental secured debt capacity: €210.0m, with the secured net leverage test binding ahead of the €957.1m allowed by the Fixed Charge Coverage Ratio
• Restricted payments capacity: €52.0m
• Equity cure required at 20% lower EBITDA: €22.9m as an EBITDA cure vs. €80.0m as a debt paydown

These six numbers are the practical inputs to almost everything that follows: the €210.0m tells the corporate development team how large an acquisition it can debt-fund without a consent process, the €52.0m sets the ceiling on a sponsor dividend, and the 8.6% EBITDA cushion is the number a rating agency or a distressed desk will quote when arguing about how close the structure sits to an amendment negotiation.

Would you like to explore how the answer changes if the new debt were raised as unsecured rather than secured borrowing, or if a portion of the capital structure carried floating rather than fixed coupons?