Covenants
Leverage covenant
A leverage covenant caps your debt as a multiple of EBITDA, tested every quarter. It is rarely one number and rarely one measure: most facilities test several, on a schedule that tightens each year.
Also called net debt to EBITDA covenant · leverage ratio · gearing covenant · senior leverage · total leverage
Fund capital buys leverage and charges for it. Bank senior stops around 3.5x where unitranche stretches past 4x.
| Instrument | Net debt to EBITDA |
|---|---|
| Conservative senior | 1.5x to 3.0x |
| Bank senior | 2.5x to 3.5x |
| Unitranche | 4.0x to 4.5x |
Market convention at £3-15m. Individual facilities vary.
The measure is never just one measure
Net debt divided by EBITDA is the headline, and it is the one borrowers quote. It is rarely the only test in the agreement. A facility with more than one layer of debt will usually test senior leverage and total leverage separately, so the senior lender can protect its own position independently of whatever sits behind it. A business at 3.0x senior and 4.2x total has two covenants to pass, not one, and the tighter of the two is the one that binds.
The distinction matters most when junior debt is added later. An accordion or a mezzanine tranche drawn in year three moves total leverage without touching senior leverage, so a structure that only tests total leverage constrains a bolt-on that a structure testing both would permit at the senior level. Which measures appear in your agreement is a negotiation about future flexibility, not a formality.
Gross against net, and why the cash definition matters
Net debt deducts cash from borrowings; gross debt does not. Most UK lower-mid-market facilities test net, which sounds like the borrower-friendly outcome and usually is. The argument is in what counts as cash.
Lenders commonly cap the deduction, exclude cash held in overseas subsidiaries where repatriation is uncertain, exclude cash subject to any charge, and exclude customer deposits or client money. A business with £2m on the balance sheet may find only £1.2m of it deductible. The definition belongs at term-sheet stage, because a cap on netting is materially the same as a tighter covenant and is far easier to argue about before the documents are drafted.
What counts as debt
The numerator is contested more often than the multiple. Bank facilities and loan notes are uncontroversial. The live questions are leases, deferred consideration, shareholder loans and any invoice finance or asset finance already in place.
Leases are the largest single swing item since IFRS 16 brought most of them onto the balance sheet. A property-heavy business can see leverage move by half a turn or more depending on whether lease liabilities count, which is enough to change the facility size. Deferred consideration from a prior acquisition and any earn-out are usually debt unless carved out. Shareholder loans are usually excluded where they are properly subordinated and non-cash-paying, but that requires a subordination deed, not an assurance.
The covenant is a schedule, not a number. A facility opening at 3.5x commonly tightens by a quarter-turn a year.
| Facility year | Covenant level |
|---|---|
| At close | 3.5x |
| Year 2 | 3.25x |
| Year 3 | 3x |
| Year 4 | 2.75x |
| Year 5 | 2.5x |
Illustrative step-down on a five-year facility. Schedules are negotiated deal by deal.
The denominator: which EBITDA
EBITDA in a facility agreement is a defined term, not the statutory figure. It is normally the adjusted number agreed at close, rolled forward on the last twelve months and tested quarterly. The adjustments accepted at close are the ones you keep; new adjustments in later periods usually need the lender's agreement.
Three constructions do most of the work. Pro forma treatment of acquisitions, so a business bought mid-year contributes a full twelve months of earnings against the debt that funded it. Run-rate synergies, usually capped as a percentage of EBITDA and time-limited. And exceptional items, where the definition of exceptional is narrower than most management teams expect. Where these land decides your capacity as surely as the multiple does.
The schedule: why the level tightens
A leverage covenant is rarely a single number for the life of the loan. It usually opens near the entry leverage and steps down each year, commonly by around a quarter of a turn, on the reasoning that amortisation and earnings growth should both be reducing the ratio anyway.
That construction is reasonable when the plan holds and unforgiving when it does not. A business repaying on schedule but growing slower than forecast can find the covenant tightening faster than performance improves, producing a breach with nothing obviously wrong in the business. The useful exercise before signing is to run the step-down against a downside case rather than the plan, and to check the tightest point rather than the opening level.
Where a step-down is unavoidable, two things soften it: a slower gradient in the early years while an integration or capex programme completes, and a reset mechanism tied to a defined event such as a completed acquisition.
The cover ratios tested alongside it
Leverage caps the stock of debt. It says nothing about whether you can pay for it, which is why most facilities pair it with at least one cover test.
Interest cover divides EBITDA by cash interest and asks whether earnings comfortably exceed the cost of carry. Debt service cover is tighter, because it counts scheduled amortisation alongside interest and measures against cash rather than earnings, so a heavily amortising facility can pass leverage and fail debt service. Where the business is capital-intensive, a cashflow or capex cover test appears too, measuring what is left after maintenance capex.
In a rate environment where interest has risen faster than earnings, the binding constraint has moved for many borrowers from leverage to cover. A structure sized purely on a leverage multiple can fail its cover test on day one, which is a modelling exercise worth doing before a term sheet is signed rather than after.
Leverage is one of four tests. Most £3-15m facilities carry two or three of these, not leverage alone.
| Test | What it measures |
|---|---|
| Debt service cover | Interest + amortisation |
| Interest cover | EBITDA over interest |
| Leverage | Net debt over EBITDA |
| Capex / cashflow cover | Capital-intensive only |
Market convention. Levels are negotiated and vary by sector and structure.
Where leverage is the wrong test
Not every facility is sized on earnings. Asset-based lending is governed by a borrowing base and a loan-to-value test against receivables, inventory and plant, with advance rates set per asset class rather than a multiple of EBITDA. Property-backed lending runs on LTV and often a separate interest-cover test on rent.
This matters at £3-15m because many businesses in the band qualify for both a cash-flow facility and an asset-backed one, and the two are governed by entirely different covenant architecture. A business with volatile earnings and a strong debtor book may pass an ABL borrowing base comfortably while failing any sensible leverage covenant, and the choice between the two structures is therefore a covenant question as much as a pricing one.
How the covenant sets your facility size
Most borrowers meet this covenant first as a constraint on borrowing rather than a compliance obligation. If a lender will underwrite 3.0x and your adjusted EBITDA is £2m, the senior facility is around £6m before anything else is considered.
This is why add-backs matter so much in the pack. Every £100k of EBITDA a lender accepts is roughly £300k of additional capacity at 3.0x, and every £100k struck out removes the same. The negotiation over adjustments is not accounting housekeeping; it is the facility size argument in disguise, and it is won with evidence rather than assertion.
What to negotiate, in order
The opening multiple matters less than five things around it. The definitions of debt and EBITDA, which move the ratio without anyone touching the covenant. The netting cap on cash. The step-down gradient, tested against a downside. Whether senior and total are tested separately, which decides your room for junior debt later. And acquisition treatment, so a bolt-on funded mid-year does not breach on the day it completes because the debt lands before twelve months of the acquired earnings do.
That last one is standard to fix through pro forma or annualised treatment, but only if someone asks at term-sheet stage. After the documents are drafted it becomes an amendment, and amendments are priced.
Common questions
What is a good leverage ratio for a UK business?
There is no single answer, because the level a lender will underwrite depends on the instrument and the stability of your earnings. At £3-15m, bank senior is commonly 2.5x to 3.5x EBITDA and unitranche runs nearer 4x to 4.5x. A conservative senior structure may sit at 1.5x to 3.0x. What matters more than the headline is whether the level leaves 25 to 30% headroom against a realistic downside.
What is the difference between senior leverage and total leverage?
Senior leverage counts only the senior facility against EBITDA. Total leverage counts every layer of debt, including mezzanine, junior notes and anything ranking behind the senior lender. A structure with both tests gives the senior lender protection independent of what sits behind it, and gives the borrower a clearer view of how much junior debt can be added later without breaching.
Do leverage covenants get tighter over time?
Usually. Most facilities open near the entry leverage and step down annually, commonly by around a quarter of a turn, on the assumption that amortisation and growth are both reducing the ratio. The risk is that a business repaying on schedule but growing slower than plan loses headroom faster than it gains performance, so the schedule should be tested against a downside case before signing.
Do leases count as debt in a leverage covenant?
It depends on the definition in your agreement, and it is one of the most material points to settle. Since IFRS 16 brought most leases onto the balance sheet, a property-heavy or vehicle-heavy business can see leverage move by half a turn or more depending on whether lease liabilities are included. It settles at term-sheet stage rather than in documentation.
Can I deduct all my cash when calculating net debt?
Rarely all of it. Most facilities cap the deduction and exclude cash that is charged, held overseas where repatriation is uncertain, or held on behalf of customers. A business with £2m on the balance sheet may find substantially less than that deductible, and a cap on netting has the same practical effect as a tighter covenant.
What happens if I breach a leverage covenant?
A breach is an event of default, which entitles the lender to reprice, impose conditions, require an equity injection or in principle accelerate the loan. In practice most breaches at this size are resolved consensually, but resolution has a cost in fees and in negotiating position. Many facilities include an equity cure right allowing shareholders to inject funds to fix the ratio, usually capped in frequency.
Is leverage the only covenant I will have?
Almost never. Most UK lower-mid-market facilities pair leverage with at least one cover test: interest cover, debt service cover, or a cashflow test where the business is capital-intensive. Debt service cover is often the tighter constraint because it counts scheduled amortisation as well as interest, so a facility can pass leverage and fail debt service.
Do asset-based facilities have leverage covenants?
Generally not in the same form. Asset-based lending is governed by a borrowing base with advance rates against receivables, inventory and plant, and tested on loan-to-value rather than a multiple of earnings. A business with volatile earnings and a strong debtor book can pass an ABL borrowing base while failing any sensible leverage covenant, which makes the choice between structures a covenant question as well as a pricing one.
The full treatment sits in the guide: loan covenants explained.
This page explains a term as it is used in the UK lower-mid-market. It is general information, not advice on any particular facility. Terms vary between lenders and between deals, and the drafting in your own agreement governs.