What happens in a covenant breach in an LBO?
A covenant breach occurs when the target fails to meet a maintenance clause (e.g. senior leverage above the agreed cap). Lender rights escalate in stages:
- Cure period (30 days): the sponsor can provide an equity cure and lift EBITDA virtually.
- Acceleration: after the cure period expires, the lender can call the entire loan due.
- Default interest: the coupon rises by 200–500 bps.
- Covenant reset: negotiation with the lender, new limits in exchange for an equity injection.
- Restructuring: on repeated breaches, a debt-to-equity swap or a sale.
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- EBITDA falls from $40m to $32m
- Senior leverage rises from 4.0x to 5.0x
- Maintenance cap: 4.75x → breach
The sponsor provides an equity cure of $8m. EBITDA is lifted virtually to $40m, leverage back to 4.0x. The cure limit is usually capped at 2 cures per 12-month period.
- Lender position on breach: leverage for a higher margin or new terms.
- Sponsor position: inject more equity or accept restructuring.
- Reputation: repeated breaches on a PE track record hurt at the next fundraise.
With Cov-Lite there is no automatic trigger — distress becomes visible later, then harder. Cross-default clauses mean: a breach on the senior automatically triggers a default on Mezzanine and Holdco debt.
Question: "As a sponsor, what would you do in a covenant breach?"
Answer: "Talk to the lender proactively and immediately, before the cure period lapses. Equity cure as the short-term fix, a restructuring plan as the medium-term one. Lenders value transparency more than attempts to disguise the breach"