What are covenants in the context of leveraged finance?

Covenants in the context of leveraged finance are agreements or conditions included in loan documents or credit agreements that are designed to protect lenders and ensure that borrowers maintain certain financial metrics or adhere to specific operational guidelines. These covenants serve as monitoring mechanisms for company performance, allowing lenders to track whether the borrower is abiding by the terms of the loan and remaining financially stable.

These covenants can take various forms, including affirmative covenants, which require the borrower to take certain actions (like maintaining insurance or providing financial statements), and negative covenants, which restrict certain activities (such as taking on additional debt or selling significant assets). This framework helps lenders mitigate their risk and allows them to intervene if the borrower's situation deteriorates, ultimately safeguarding their investment.