• Financial covenants continue to be a key feature of real estate, development and project financings with an increased focus from lenders and borrowers on the component parts of the various ratios.
  • The precise wording of each financial covenant definition (including carve-outs and assumptions) can be critical in determining whether financial covenants are met when they are tested.
  • Notwithstanding the safeguards provided by financial covenants, lenders are often keen to ensure that earlier warning triggers are included in the form of cash trap covenants, and borrowers will often seek to include equity cure rights to offer breathing space.

Since 2015, there has been a rising tide of "cov-lite" leveraged loans issued in Europe which do not contain maintenance financial covenants that, if included, would be tested on a quarterly or semi-annual basis. This trend has continued despite the onset of pandemic-related lockdown. In many cases, private equity borrowers have negotiated short-term waivers in relation to the requirement to test "springing" leverage financial covenants which would normally be tested for the benefit of revolving facility lenders when the relevant facility is drawn,

Outside of the leveraged finance market however, financial covenants remain a key feature of a wide range of loan financings. This article discusses the financial covenant packages used on project financings, and on real estate and development financings, together with some of the common structuring and negotiation points that arise.


The traditional project finance model involves using long-term contracted cashflows to repay loan facilities used to (re)finance the construction of the relevant asset (such as a renewable energy plant or a public-private partnership asset). Therefore, the financial covenant package generally consists of:

  • a Debt Service Cover covenant which tests the cashflows of the borrower (generally a special purpose vehicle) against its debt service obligations (interest payments and fees) over the relevant testing period and therefore its ability to service its amortising loan facilities (cashflow is used rather than EBITDA given the borrower will generally be a special purpose vehicle company with a single revenue stream which will be used to service the financing, such that this is the most appropriate metric to test rather than EBITDA which would incorporate "non-cash" accounting measures such as depreciation of fixed assets); and
  • a Loan Life Cover covenant which tests the ratio of the net present value of forecast "net cash flow" (being project revenues after deducting taxes, operating expenses, capital expenditure and other expenses) over the remainder of the tenor of the financing to the outstanding principal amount of all loans as at the relevant testing date. Therefore, the Loan Life Cover covenant also measures cashflows against debt service, but is over the unexpired life of the project rather than solely over the relevant testing period. Loan Life Cover covenants are not included in all project finance transactions and may instead be used as a lock-up ratio which must be satisfied as a condition to the borrower making a distribution to its shareholders.

Forward and backward-looking financial covenants and lock-ups

Traditionally, project finance transactions included both a historic or "backward-looking" Debt Service Cover covenant (tested in relation to the relevant six or twelve month period ending on the testing date) and a forecast or "forward-looking" Debt Service Cover covenant (tested in relation to forecast cash flows and debt service for the relevant six or twelve month period starting on the testing date). However, it is common to see historic Debt Service Cover covenants only, with the relevant default ratio set at a level such as 1.05:1, often with a lock-up ratio (which is required to be met to permit the borrower to pay dividends) set at a higher level such as 1.10:1.

The Debt Service Cover ratio should allow for some element of underperformance against the projected performance that is set out in the financial model agreed between the borrower and arrangers or lenders at the outset of the transaction. For example, repayment profiles are often sculpted to show a minimum projected Debt Service Cover ratio of 1.20:1 for each testing period over the term of a project financing to allow for the occurrence of unexpected events or delays.

Interaction with other aspects of financings and equity cures

The formulation of Debt Service Cover covenants may interact with other aspects of project finance facilities agreements. For example, borrowers are increasingly using debt service reserve facilities as an alternative to funding debt service reserve accounts to address the borrower's inability to meet debt service from cashflows. Where a debt service reserve facility is used, borrowers will often argue that the cost of repaying any drawn loans under that facility should not be included in "debt service" for the purpose of calculating the Debt Service Cover covenant. This is to avoid a situation whereby drawing down a debt service reserve facility could reduce the Debt Service Cover ratio on future testing dates by increasing "debt service".

Parties may negotiate how any equity cure mechanics interact with the use of a debt service reserve facility, given that such a facility can generally only be used to address a temporary cashflow shortfall rather than to address any breach of the Debt Service Cover "default ratio". Borrowers will seek to ensure that the undrawn amount of any debt service reserve account or debt service reserve facility is added to the net present value of forecast cashflow for the purpose of calculating the Loan Life Cover ratio, given these amounts should be available to fund debt service (subject to any drawstops on the borrower's ability to draw the debt service reserve facility).

Debt Service Cover and Loan Life Cover ratios may vary depending on the nature of the borrower's cashflows. Where the tenor of a financing for a renewable energy generation asset extends beyond the expiry of the relevant subsidy scheme, lenders may insist on a higher Debt Service Cover or Loan Life Cover covenant "lock-up ratio" during that merchant "tail" period to reflect the fact that the borrower's cashflows are likely to be more exposed to market fluctuations in energy prices.


In the context of real estate and development finance, financial covenants provide early warning signs of a potential risk to either:

  • the underlying income from the property used to service the debt; or
  • the economic health of the borrower or its asset value relative to the debt.

The individual components of any definition used in a financial covenant will usually be determinative when testing the ratio. In light of that, we examine those individual components in detail below.

Loan to [Development] Value

While the Loan to [Development] Value covenant is undoubtedly the most frequently used risk metric in real estate facilities, the precise details of that covenant can differ from facility to facility.

On the "Loan" side, the following points should be considered:

  • Where there are multiple utilisations (for example, in a development finance facility) should the "Loan" component just include the drawn amounts or should it also include any undrawn amounts (so as to test the position assuming that all such utilisations have been made, giving a "total commitments to value" covenant)?
  • What, if any, deductions should be permitted when calculating the "Loan" component? Borrowers frequently request that any amounts sitting in a lender-blocked account (such as a deposit account, a disposals account, a cure account or a cash trap account) should be deducted from the "Loan" component on the basis that they could be applied against the drawn amounts. When considering a request of this nature, lenders and their advisers should give thought to the precise source(s) of those amounts and whether those amounts are to be applied towards a specific purpose. For example, there may be insurance prepayment proceeds in the relevant deposit account which are to be applied in reinstatement of a property and, as a result, would never be available to be applied in prepayment of drawn amounts. It would be inappropriate to allow an amount equal to those proceeds to be deducted from the "Loan" component of the covenant. A lender may often address this concern by only allowing amounts in those accounts which are to be applied in prepayment of drawn amounts to be deducted from the "Loan" component of the covenant. Further protection may be obtained by putting a timeframe around when such amounts must be applied in prepayment if they are to be permitted as a deduction from the "Loan" component, for example by providing that only amounts which are required to be applied in prepayment of drawn loans on or before the next interest payment date may be deducted.

In respect of the "Value" component of the Loan-to- [Development] Value covenant, while it is usually less heavily negotiated, consideration should be given to the following points:

  • Who can choose the valuer that will provide the valuation? Will this be solely at the discretion of the lender or agent, or will the borrower expect to provide a list of permitted valuers or expect a consultation right?
  • Should any assumptions apply to the valuation? For example, should it be assumed that practical completion has occurred? Should it be assumed that stabilisation has occurred (this may be based on a minimum occupancy percentage rate (often at least 80%) and may also require that certain financial covenants be satisfied)? Should it be assumed that a minimum occupancy (often split between residential and commercial for mixed-use developments) has been achieved? Ultimately, the assumptions will depend on how the lenders are documenting the ratios as part of their asset management process but it is important that the drafting reflects the commercial intention.
  • When can a lender call for a valuation and, if a borrower independently calls a valuation, will it be obliged to deliver a copy of that valuation to the lender? Linked to this is the need to include language which makes clear which valuation will be used as the basis for any financial covenant testing - must it be a valuation approved or instructed by the lender?

Loan to Cost covenant

A Loan to Cost covenant is commonly used in development financings. This is because the ultimate value of the development will not be the same as its value immediately after practical completion and therefore assumptions must be made when calculating the Loan to [Development] Value. Therefore, lenders often prefer to test the amount of the facility (drawn and undrawn) against the total budgeted costs (as determined by the project monitor). The components of this Loan to Cost covenant are not subject to the same level of assumptions as is the case with the Loan to [Development] Value covenant (although the project monitor must still project the budgeted costs based on the information provided by the borrower). When calculating the Loan to Cost covenant, the points noted above in respect of calculating the "Loan" component of the Loan to [Development] Value covenant apply equally when considering the "Loan" component of the Loan to Cost covenant. The definition of "Budgeted Costs" is the "Cost" component of this covenant. Usually the costs will be determined by reference to a budget approved by the lenders as a condition precedent to drawing the facility but it is important to consider whether the finance costs associated with the development should be considered in this definition and whether cost overruns or contingency amounts should also be included.

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Originally Published by Butterworths Journal of International Banking and Financial Law

This article contains a general summary of developments and is not a complete or definitive statement of the law. Specific legal advice should be obtained where appropriate.