Covenant Lite #22: Guardrails Gone: The Erosion of Covenants in Private Credit

Pressure to deploy in private credit has led to fewer investor protections

For years, investors treated covenants like highway guardrails: rarely noticed but invaluable in an emergency. But today, the market is tearing these guardrails down piece by piece. Covenant-lite has become covenant-void, leaving the illusion of safety—but nothing substantial between investors and the cliff’s edge.

Welcome to the world of investing in private credit in 2025. Before going much further, we should explain what we mean by covenants. In private credit and lending more broadly, covenants are specific conditions or rules set within a loan agreement to protect lenders and investors. Think of covenants as safety checks or early-warning signals designed to monitor a borrower’s financial health and behavior throughout the life of a loan.

These safeguards typically fall into three main categories:

1. Financial Maintenance Covenants

These covenants require the borrower to maintain certain financial metrics—usually calculated every quarter. Common examples include:

• Leverage Ratio Covenant (e.g., debt-to-EBITDA must not exceed 5.0x)

• Interest Coverage Covenant (e.g., EBITDA must cover interest payments by at least 2.0x)

If the borrower breaches these covenants (fails the test), lenders gain early warning of trouble and can step in to renegotiate terms or take protective actions before more serious defaults occur.

2. Negative Covenants

Negative covenants restrict the borrower’s actions without lender approval. Typical restrictions include:

• Limits on taking on additional debt

• Restrictions on dividend payments or distributions to shareholders

• Limits on asset sales or transferring key assets out of lenders’ reach

• Restrictions on making acquisitions or investments without lender consent

These covenants protect lenders by preventing borrowers from making risky financial moves.

3. Affirmative Covenants

These require borrowers to perform certain actions regularly, such as:

• Providing timely, detailed financial reporting to lenders

• Maintaining adequate insurance coverage

• Keeping key assets in good condition and preserving business operations

• Complying with applicable laws and regulations

Affirmative covenants ensure transparency, enabling lenders to proactively monitor a borrower’s health.

In short, covenants are lenders’ primary tools for managing risk—acting as guardrails that prevent small financial issues from becoming major problems. Without covenants, lenders and investors lose their early-warning systems, which can result in significantly higher risks and potential losses down the road.

A loan with at least one financial maintenance covenant is considered “covenanted”. Loans with more than one financial maintenance covenant are considered “covenant-heavy”, while those without any maintenance covenants are considered “covenant-lite” or “cov-lite” as the abbreviation.

How Covenants Have Eroded – Then vs. Now (2015–2025)

Covenants 10 Years Ago (2015)

A decade ago, covenants were the norm—not the exception—in private credit. Virtually every loan, especially in the lower-middle and middle markets, had at least one clear financial maintenance covenant, often more.

In the lower-middle market (companies with EBITDA below $25 million), nearly every loan—approximately 98%—included at least one maintenance test, typically a leverage or interest coverage ratio. Even in the upper-middle market (companies with EBITDA above $50 million), covenants remained standard, with less than 5% of loans structured as covenant-lite.

Deals of $500 million or more—today’s "mega-deals"—were relatively uncommon, but when they did occur, lenders still maintained considerable discipline, with covenant-lite terms representing only about 2% of these larger transactions.

Covenants weren’t just frequent—they were robust. Leverage covenants commonly allowed for just 15–25% headroom above initial debt levels, ensuring lenders had ample early warnings. Negative covenants strongly restricted additional borrowing, asset transfers, or dividend payments without explicit lender approval. Affirmative covenants mandated frequent, timely financial reporting, providing lenders transparent insight into borrowers’ performance.

Covenants Today (2025)

Fast-forward to today, and the private credit landscape looks radically different. Covenants have significantly eroded, transforming from a fundamental lending standard to an optional add-on—especially in larger transactions.

In the lower-middle market (companies below $25 million EBITDA), covenant erosion remains modest.

The erosion becomes clearer in the upper-middle market (companies above $50 million EBITDA). Approximately 30% of recent deals are covenant-lite, meaning lenders receive significantly fewer protections.

Leverage tests, if present at all, often include extensive cushions—typically allowing borrower EBITDA to drop by 30–40% before triggering a breach. EBITDA definitions have become heavily adjusted, allowing borrowers wide flexibility through add-backs and projections, effectively diluting or delaying lender protections.

However, the most dramatic transformation has occurred in the mega-deal segment (deals exceeding $500 million in debt) with approximately 50–55% of new mega-deals entirely lacking financial maintenance covenants.

Influential sponsors and intense competition among lenders have normalized cov-lite or even covenant-free structures, leaving lenders exposed until the borrower faces severe financial distress or outright defaults.

Negative covenants have also weakened substantially. Borrowers commonly negotiate generous carve-outs, permitting significant incremental debt, dividends, or asset transfers with limited oversight.

Affirmative covenants, while still present, often feature diluted reporting requirements—less frequent, less detailed, and less timely—further diminishing lenders' visibility into borrowers’ true financial condition.

Today, the era of comprehensive covenant packages feels like a distant memory. Lenders increasingly navigate a market defined by minimal early-warning signals, greater borrower autonomy, and heightened risk—truly a world of covenant-lite drifting into “covenant-void” territory.

Case Study: Zendesk—A Mega-Deal That Set the Bar for Covenant Erosion

In late 2022, Zendesk, a publicly traded SaaS company, became the subject of a major leveraged buyout led by prominent private-equity sponsors Hellman & Friedman and Permira.

To finance this $10 billion takeover, the sponsors turned to the private credit market, securing a record-setting $5 billion unitranche loan led by top-tier direct-lending institutions, notably Blackstone Credit and Owl Rock. At the time, this was one of the largest direct-lending deals ever arranged—marking a watershed moment for private credit.

Despite its unprecedented size and leverage, the Zendesk financing stood out most notably for the stark absence of traditional covenant protections. Structurally, the deal carried no ongoing financial-maintenance tests (such as a quarterly leverage or interest coverage ratio)—making it fully covenant-lite.

The only conditional test included was a minimal "springing" covenant on a relatively small revolving facility, which would activate if borrowing exceed a relatively high utilization threshold (35-40%).

The financial terms were equally aggressive. On the surface, Zendesk was leveraged at around 7.0x EBITDA, already high by typical software lending standards. But beneath this headline figure lay significant "adjustments" to EBITDA.

Specifically, the agreement allowed substantial add-backs for projected cost savings, future synergies, and one-time charges expected from integrating Zendesk into the sponsors’ existing technology portfolios.

Industry reports and deal analysis at the time estimated these adjustments boosted Zendesk’s EBITDA by more than 20% above its true cash-generation capacity. On a GAAP-adjusted basis, true leverage likely exceeded 8.5x EBITDA—substantially higher than initially reported.

Zendesk’s documentation further tilted heavily toward borrower flexibility. Negative covenants allowed considerable incremental debt to be added after closing, provided leverage ratios remained loosely defined at or near initial closing levels. Restrictions on dividends and acquisitions were minimal, giving sponsors wide latitude in managing Zendesk’s capital structure without lender input.

This deal exemplifies a broader shift in the upper reaches of the private credit market. The Zendesk financing effectively removed the guardrails that once gave lenders meaningful oversight into borrower performance, setting a clear precedent for subsequent large-scale financings.

Similar mega-deals quickly followed suit: Coupa Software’s $3.2 billion take-private, Avalara’s $2.75 billion acquisition financing, and The Access Group’s $4 billion unitranche in Europe all embraced covenant-lite terms.

Zendesk marked a significant inflection point in private credit, clearly demonstrating that at the high end of the market, covenant erosion has shifted from marginal to mainstream.

For lenders and limited partners investing in such mega-transactions, the Zendesk case sent a clear message: the risk profile has changed significantly, with covenant protections that investors previously considered essential now effectively optional.

It should be noted that even for loans with financial maintenance covenants (i.e. covenanted loans) the lending environment of today is much more precarious than a decade ago. Sponsors have become increasingly savvy about structuring credit agreements to ensure maximum flexibility.

Loosely drafted definitions for EBITDA Add-backs can inflate EBITDA significantly, making a leverage test much weaker than it appears. Similarly, sponsors use intentionally broad definitions of Permitted Investments & Acquisitions to buy other companies, further boosting EBITDA by assuming large synergies and cost savings.

With inflated EBITDA figures, sponsors may be able to justify paying themselves large dividends, extracting cash from the business even as the underlying leverage climbs. They may also layer on additional debt that is pari-passu with the original loan given generous Incremental Debt & Builder Baskets, increasing risk and diluting a lender’s position.

Maintenance covenants or not, it is definitely buyer beware in private credit today.

Key Drivers of Covenant Erosion

The shift from covenant-heavy to covenant-lite—and increasingly to covenant-void—structures in private credit hasn’t happened by accident. Several powerful market forces have steadily weakened lender protections:

1. Competitive Pressure Among Lenders

Massive inflows into private credit funds have created fierce competition. With more lenders chasing fewer quality deals, sponsors and borrowers have gained significant negotiating leverage. To win deals, lenders often accept weaker covenant terms.

2. Rise of Mega-Unitranche Deals

The rapid growth of very large private credit deals ($500 million and above) has blurred the line between private credit and syndicated markets. These mega-unitranches compete head-to-head with traditional bank-led syndicated loans, adopting looser terms—including covenant-lite—previously seen only in public markets.

3. Strong Sponsor Influence

High-quality sponsors leverage their relationships and market power to secure extremely borrower-friendly terms. These sophisticated, large-cap private equity firms frequently negotiate covenant-lite or covenant-void structures, pushing private credit terms closer to broadly syndicated market standards.

4. Expansion of EBITDA Definitions and Add-Backs

Broadly defined and heavily adjusted EBITDA has significantly diluted covenant effectiveness. Sponsors increasingly negotiate add-backs for projected synergies, cost savings, and one-time charges—often inflating EBITDA by 20–30%, which makes leverage ratios look artificially safe.

5. Increased Documentation Complexity

Loan documents have become significantly more intricate, introducing complex carve-outs and baskets (such as builder baskets and permitted investments). This complexity allows sponsors greater flexibility to incur incremental debt, pay dividends, and conduct acquisitions—weakening covenant protection in practical terms, even when maintenance covenants technically remain in place.

Taken together, these forces have fundamentally reshaped private credit terms, significantly tilting the risk-reward dynamic toward borrowers and sponsors. For lenders and LPs, understanding these drivers of covenant erosion is essential to accurately evaluating risk in today's market.

Implications & Risks of Covenant Erosion

The decline of covenants in private credit isn’t just a technical issue—it carries serious implications for lenders and investors alike. Here are three key ways covenant erosion impacts investor outcomes:

1. Delayed Detection of Problems

Strong covenants once served as early-warning signals, allowing lenders to act quickly when borrowers began to struggle. With covenants weakened or absent, lenders often have no visibility into financial deterioration until problems become severe. By the time issues surface, recovery prospects may have already significantly worsened.

2. Increased Risk of Principal Loss

Historically, strong covenants have correlated with higher recovery rates in distressed scenarios. Without these protections, lenders lose critical bargaining power during restructuring or workout negotiations, leading to lower recoveries and higher risk of permanent capital impairment.

3. Mispricing of Risk

Eroded covenants can create the illusion that credit quality remains strong—even when underlying leverage is rising due to inflated EBITDA definitions or permissive incremental debt. Investors may underestimate true risk and inadvertently accept weaker terms without receiving sufficient compensation through higher yields or fees.

The Road Ahead: Navigating the Covenant-Lite Landscape

The erosion of covenants has fundamentally reshaped the private credit market, and there’s no indication this trend will reverse anytime soon. As we move forward, investors must recalibrate expectations and adapt their diligence processes to reflect this new reality.

What Should Investors Expect?

• Continued Covenant Weakness:
  Competitive pressure among lenders and influential sponsor negotiating power will likely continue to weaken covenants, particularly at the larger end of the market.

• Potential Fallout in a Downturn:
  The next credit cycle will put covenant-lite and covenant-void deals to the test. Without early-warning protections, investors will likely experience delayed visibility into borrower distress, potentially leading to higher losses and lower recovery rates.

As private credit moves further into covenant-lite territory, lenders face a market that’s fundamentally changed—one marked by looser terms, inflated EBITDA, and sponsors empowered with unprecedented flexibility.

Guardrails have quietly faded into the background, leaving investors to recalibrate their own approaches to risk assessment, diligence, and pricing discipline. Navigating this evolving landscape successfully will require clarity, vigilance, and a willingness to rethink assumptions about borrower safety.

Covenant Lite