How are covenant step-downs tracked over the life of a loan?
Step-downs are tracked with a dated schedule that lists every covenant, every test date and the required level in force on each date. The schedule is built from the original agreement and updated each time an amendment, waiver or reset changes a level, so every covenant test is run against the correct level.
The schedule is the single reference for what the borrower owes on each date. Without it, the required level lives in a loan agreement and a stack of amendments, and the person testing the covenant has to piece it together every quarter. That is where tests against outdated levels come from.
What is a covenant step-down?
A step-down is a scheduled tightening of a financial covenant written into the loan agreement at closing. A maximum leverage covenant might start at 4.50x and fall to 3.50x over three years, or a minimum coverage covenant might rise from 1.15x to 1.25x. The borrower agrees to the path up front, usually because the lender expects earnings to grow or debt to fall as the loan amortizes.
Step-downs are common on acquisition and growth loans, where leverage starts high. They are easy to miss because nothing happens on the date the level changes: no document arrives and no payment changes. The first sign is often a compliance certificate that shows a pass against the old level.
What does a covenant step-down schedule look like?
Example only. The schedule below covers a maximum funded debt to EBITDA covenant tested quarterly on a trailing twelve months basis, with step-downs written into the original agreement. Listing each test date, rather than just the change points, makes it obvious which level applies to which quarter.
| Test period ending | Maximum funded debt to EBITDA | Source |
|---|---|---|
| Quarter 4, Year 1 | 4.50x | Original agreement, section 6.1 |
| Quarter 1, Year 2 | 4.50x | Original agreement, section 6.1 |
| Quarter 2, Year 2 | 4.25x | Original agreement, section 6.1 |
| Quarter 3, Year 2 | 4.25x | Original agreement, section 6.1 |
| Quarter 4, Year 2 | 4.00x | Original agreement, section 6.1 |
| Quarter 1, Year 3 onward | 3.75x | Original agreement, section 6.1 |
How do you build the schedule from the loan agreement?
Build the schedule once, at closing, and have someone other than the person who built it check it against the agreement. Most later errors come from a schedule that was wrong from the start.
- 1Read the financial covenants section and the definitions section of the agreement together.
- 2List each financial covenant, its direction (minimum or maximum), how often it is tested and over what period.
- 3Write out every test date through maturity, with the required level for each one.
- 4Note any conditions attached to a level, such as a step-down that only applies if an acquisition closes.
- 5Record the section of the agreement each level comes from.
- 6Have a second person check the schedule against the agreement and sign off.
What is the difference between a waiver, an amendment and a reset?
These three terms are often used loosely, but they have different effects on the schedule. Getting them right determines whether the next test uses the original level or a new one.
| Change | What it does | Effect on the schedule |
|---|---|---|
| Waiver | Lender agrees not to enforce its rights for a specific breach and period | None for future dates. Log it, but the next test uses the scheduled level |
| Amendment | Changes the agreement, such as a definition, level or test date | Update affected levels from the effective date onward |
| Covenant reset | An amendment that replaces a set of levels, often after a breach or a weaker year | Replace the remaining schedule with the new levels |
| Covenant holiday | An amendment suspending a test for set periods | Mark those dates as not tested, with the source |
How should you keep a covenant amendment history?
Keep an amendment log next to the schedule. Each entry should say what changed, when it took effect, why it was done and who approved it. When the schedule is updated, the old levels should be kept and marked as superseded, not deleted, so anyone can see what the level was on any past date and why it changed.
Example only. The log below continues the schedule above. After a weaker Year 2, the borrower breached the 4.00x level in Quarter 4. The lender waived that breach, then amended the agreement to reset the remaining levels.
| No. | Effective date | Type | What changed | Terms | Approved by |
|---|---|---|---|---|---|
| 1 | Q4, Year 2 test | Waiver | Breach of 4.00x maximum (actual 4.20x) waived for that period only | Waiver fee | Credit officer per authority matrix |
| 2 | Q1, Year 3 | Amendment (reset) | Maximum leverage reset to 4.25x for Q1 to Q2 Year 3, 4.00x for Q3 to Q4 Year 3, then 3.75x | Rate increase, monthly reporting | Credit committee |
How do you make sure each test uses the level in force?
Test against the schedule, never against memory or the original term sheet. When the compliance certificate arrives, look up the test date on the schedule, take the required level from there and recalculate the borrower's figure under the agreement's current definitions, since an amendment may have changed a definition as well as a level.
Example only, continuing the case above. In Quarter 2 of Year 3, the borrower reports leverage of 3.90x. Under the original schedule the maximum would be 3.75x, a breach. Under the reset it is 4.25x, a pass with headroom of (4.25 - 3.90) / 4.25, about 8.2%. Testing against the wrong level would either raise a false breach or, in the reverse case, miss a real one.
How do you see a step-down coming before it bites?
Calculate headroom against the next scheduled level as well as the current one. A borrower with comfortable headroom today can be in breach the day a step-down takes effect without any change in results.
Example only, continuing the case. At 3.90x, the borrower passes the 4.25x level in Quarter 2 of Year 3, but the level falls to 4.00x in Quarter 3. Headroom against 4.00x is only 2.5%. With funded debt of $9,750,000, the borrower needs trailing EBITDA of at least $2,437,500 to pass at 4.00x, against $2,500,000 now. That is a conversation to have with the borrower before the quarter ends, not after.
What are the common mistakes in tracking step-downs?
Almost every error in this area comes from a schedule that was not updated, or a test that did not use the schedule.
- Testing against the original level after a step-down date has passed.
- Treating a waiver as if it changed future levels.
- Updating a level but not a definition changed by the same amendment.
- Overwriting old levels, so nobody can see what applied on a past date.
- Missing a conditional step-down that was triggered by an event such as an acquisition.
- Relying on the borrower's compliance certificate for the required level.
How Aarvion helps
Aarvion Risk OS Commercial Credit holds each covenant's dated schedule of required levels and tests every period against the level in force, showing headroom against both the current and the next scheduled level. Waivers, amendments and resets are logged with their effective dates, and superseded levels are kept, not overwritten.
Decisions to waive, amend or reset stay with the bank's people. Each one is routed to the right signer under the bank's own credit rules and recorded with who proposed it, who approved it and when.
