Covenant Mining: How Credit Agreement Baskets Reveal Financial Flexibility

• Debt covenant baskets, like restricted payments and permitted liens, define what management can still do with cash and collateral.
• Read the definition sections and schedules first, then numeric tests and blackout periods to compute usable capacity.
• Pro forma adjustments for recent transactions and EBITDA addbacks are essential to estimate remaining headroom.
• Permitted lien language and pari passu carveouts determine whether new secured debt can be issued without breaching covenants.
• Use SEC credit agreement exhibits and debt schedules to model incremental capacity and simulate likely management actions.

Introduction

Covenant mining is the practice of reading a borrower’s credit agreement to infer how much financial flexibility management still has. In one sentence, it means translating legal language in debt covenants into quantifiable headroom for dividends, share buybacks, asset sales, and new debt.

Why does this matter to you as an investor? Because covenant limits constrain capital allocation choices and can presage dilution, refinancing risk, or opportunistic transactions. If you want to assess downside protection, upside optionality, or the probability of covenant waivers, this is where you look first.

In this article you will learn how to read restricted payments, debt baskets, and permitted lien clauses. I will show step by step how to extract numeric capacity, run pro forma scenarios, and interpret signal events in SEC exhibits. By the end you will be able to model how much financial engineering a management team can still execute.

How Covenant Baskets Fit in Credit Agreements

Start with the architecture. A credit agreement bundles definitions, affirmative and negative covenants, and several lists called baskets. Baskets are carveouts that permit certain actions that would otherwise be restricted under the negative covenants.

Common baskets include restricted payments, investments, dividends, and liens. Each basket contains wording that conditions size, timing, or sources of permitted transactions. Read the definitions first because many baskets are limited by defined terms such as Consolidated EBITDA, Excess Cash Flow, or Total Leverage Ratio.

Key legal elements to scan

• Definitions section, for terms used in baskets.
• Schedules and exhibits, where dollar caps and lists of existing liens are often disclosed.
• Provisions that cross-reference other covenants, like those tying restricted payments to compliance with the leverage covenant.

Reading Restricted Payments and Debt Baskets Step-by-Step

Restricted payments typically govern dividends, stock repurchases, and other distributions to equityholders. They often look permissive at first glance but hide conditional tests. You have to translate text into arithmetic.

Step 1, identify the trigger and the cap

Find the clause that lists permitted restricted payments. It usually contains a general basket and specific baskets. The general basket might read, subject to compliance with the covenants, up to an amount equal to the greater of a specified number and a percentage of Consolidated Net Income or EBITDA. Record the numeric cap, the applicable period, and any carryforward rules.

Step 2, collect the inputs

Inputs include trailing EBITDA, Net Income, existing restricted payments made since the agreement date, and any permitted incremental amounts. Pull these from financial statements and the company’s SEC exhibits such as the credit agreement exhibit or debt schedules often filed as exhibits 10.1 or 4.2.

Step 3, adjust for pro forma items

Make adjustments for material recent M&A, asset sales, or equity issuances that the agreement either permits or excludes. Agreements frequently allow addbacks to EBITDA or exclude gains on certain sales from the restricted payment calculation. Apply these adjustments consistently.

Step 4, compute remaining capacity

Subtract restricted payments already used from the basket cap. If the cap is formulaic, compute the formula and then subtract prior permitted uses. This gives you the remaining dollar amount that management could legally distribute without a waiver.

Worked example

Suppose a company’s credit agreement has a restricted payments general basket equal to the greater of $50 million or 20% of Consolidated Net Income for the last 12 months. Consolidated Net Income is $120 million. The company has already paid $10 million in dividends this year.

• 20% of $120 million = $24 million.
• Greater of $50 million and $24 million = $50 million.
• Remaining capacity = $50 million minus $10 million paid = $40 million.

So management could still distribute $40 million, assuming no other tests block the payment.

Permitted Liens and Priority Structures

Permitted lien clauses define which secured borrowings are allowed without contravening the negative covenant barring additional liens. The language often lists specific permitted secured debt, customary purchase money liens, and liens securing existing debt listed in the schedule.

Understanding permitted liens is crucial because secured debt can be issued to finance a turnaround or acquisition, but it usually reduces the unencumbered asset pool and increases default risk for unsecured creditors.

What to watch for

• Absolute caps on aggregate secured debt expressed as a dollar amount or a percentage of total assets.
• Carveouts for certain types of liens, such as mechanics liens or cash management arrangements.
• Priority language, such as pari passu or senior secured, and whether the credit agreement allows subsequent liens to be senior to the existing loan.

Practical Techniques for Covenant Mining

Covenant mining is methodical. You want to convert legal text into a small set of spreadsheet calculations you can update quarterly. Here are practical steps you can follow every time you analyze a credit agreement.

1. Build a covenant map

Create a one-page map listing each negative covenant, the baskets it references, numeric thresholds, and blackout periods. That lets you see interactions at a glance and prioritize which tests are binding today.

2. Reconstruct the numeric tests

Translate terms such as “Consolidated EBITDA, for the last four fiscal quarters” into explicit formulas. Note whether the agreement permits addbacks like non-recurring expenses, litigation settlements, or integration costs. Those addbacks materially change capacity.

3. Model scenarios

Run a conservative and a permissive scenario. The conservative case strips most addbacks and assumes no waiver. The permissive case applies all contractual addbacks. If the gap between scenarios is large, management likely has negotiation room but not unlimited freedom.

4. Monitor triggers and events

Watch for payment dates, material acquisitions, and scheduled covenant tests. Review 8-K filings and credit amendment exhibits because those show whether management has sought waivers or amendments, which is a strong signal about near-term flexibility.

Real-World Examples

Let’s look at two stylized, realistic scenarios that show the method and the implications for investors.

Example A, dividend capacity at a manufacturing company

$XOM-like firm X has a restricted payments basket: cumulative permitted distributions up to 10% of Consolidated Adjusted Assets or $200 million if greater. Consolidated Adjusted Assets equal $3.2 billion. The company already used $50 million for dividends this year.

• 10% of $3.2 billion = $320 million.
• Greater of $320 million and $200 million = $320 million.
• Remaining capacity = $320 million minus $50 million = $270 million.

That tells you management can still return substantial capital without an amendment. If you hold the equity, you can model scenarios where management uses this capacity for buybacks versus debt paydown.

Example B, issuing secured debt at a capital-intensive company

$TSLA-like firm Y has a negative covenant prohibiting additional liens except for permitted liens up to $500 million and purchase money liens. Company Y currently has $300 million of secured debt listed on the schedule. A planned factory build needs $250 million in financing.

• Permitted unsecured secured debt cap = $500 million.
• Existing secured debt = $300 million.
• Available secured capacity = $200 million.

The planned $250 million would exceed the permitted secured liens by $50 million, meaning the company must either secure a waiver, use unsecured financing, or restructure the plan. That shortfall is a clear constraint.

Common Mistakes to Avoid

1. Reading only the covenant headings. Always read definitions and schedules too. Missing a single defined term can change the math materially.
2. Ignoring blackouts and lookback periods. Many baskets reset or restrict transfers around a covenant test date. Check timing carefully.
3. Forgetting pro forma adjustments. Post-closing M&A or disposals can change EBITDA and asset bases, altering basket sizes. Model these promptly from SEC exhibits or pro forma disclosures.
4. Assuming addbacks are automatic. Addbacks may require management certification or be subject to lender approval. Confirm whether they are contractual or discretionary.
5. Overlooking cross-default and cross-acceleration language. A violation of a different agreement can trigger problems even if the basket math looks clean. Map all material debt agreements together.

FAQ

Q: How do I find a company’s credit agreement?

A: Look in the company’s SEC filings, usually under exhibits. Common exhibit numbers are 10.1 for material contracts and 4.2 for indentures. 8-Ks disclose amendments. Search for the phrase credit agreement in EDGAR if you are unsure.

Q: Can management expand baskets with a lender waiver?

A: Yes, lenders can grant waivers or amendments to increase baskets. However, waivers often come with fees, tighter covenants, or higher interest rates. A pattern of frequent waivers signals weakening covenant protection.

Q: Are EBITDA addbacks standardized across agreements?

A: No. Addback language varies widely. Some agreements allow broad non-recurring or restructuring addbacks. Others limit addbacks to narrowly defined items. Read the exact addback definitions and reconcile them to the company’s reported adjustments.

Q: How do permitted liens affect unsecured bondholders?

A: Permitted liens increase the secured pool and can reduce recovery for unsecured creditors in distress. If permitted liens allow substantial new secured debt, unsecured holders face higher loss given default. Model security erosion when assessing credit risk.

Bottom Line

Covenant mining turns legal prose into numerical headroom. By mapping definitions, reconstructing formulas, and running pro forma scenarios you can quantify how much financial engineering management can still perform. That insight informs both upside optionality and downside risk for equities and credit positions.

Next steps for you: build a covenant map for two companies you follow, populate the numeric inputs from the latest 10-K or 10-Q and the credit agreement exhibit, and run conservative versus permissive scenarios. At the end of the day, the clearer your model, the better you can judge whether management is likely to use remaining capacity or instead face restrictive remedies.