- Covenants exist to provide a legally binding set of terms and conditions between a borrower and lender, most often in the context of loans and bond issuing.
- Lenders can include bond issuers, creditors, investors, and various financial institutions.
- These covenants contain a set of conditions that the borrower must meet in order to uphold the contract.
- Violating the terms of the agreement can result in a variety of consequences, depending on what has been previously agreed on and how the lender chooses to deal with the breach.
Covenants in private equity offer financial protection to the lender in the event the borrower breaches the agreement or is otherwise unable to follow through on their obligations. Some agreements can include a covenant that prevents the borrower from taking risks that would likely lead to a scenario where financial obligations cannot be fulfilled.
Covenants also provide benefits to the borrower, most notably that lenders are often willing to lend more money or impose lower interest rates because they are protected by the agreements that both parties have decided upon. Broken covenants have a range of consequences depending upon the agreement and the severity of the violation. Covenants are typically described as either affirmative or negative.
An affirmative covenant, sometimes referred to as a positive covenant, describes a clause or other stipulation within an agreement that outlines what actions the borrower is required to take. Such actions usually include adhering to certain terms, complying with relevant laws, insurance and tax obligations, maintaining credible and verifiable accounting and bookkeeping, and other activities that relate to maintaining proper upkeep of the borrower’s company or organization.
For the lender, the main purpose of an affirmative covenant is to protect them against the borrower’s potential failings to uphold good business practices or comply with pertinent laws and procedures. Occasionally, lenders may offer the borrower a grace period to rectify their error, but a broken affirmative covenant usually results in total default and full repayment of the loan, as well as any accrued interest.
Negative covenants describe actions that the borrower must not take if they wish to maintain the agreement ...