Most direct lenders treat covenant monitoring as a compliance function. That is a significant mistake.
The Monitoring Mistake
Most direct lenders treat covenant monitoring as a compliance function. That is a significant mistake.
A maintenance test is not a tripwire. It is the single most valuable risk signal a direct lender has — an early warning, a negotiating trigger, and an accounting event under IFRS 9 that drives stage migration and reserve recalibration. Treating it as a binary pass/fail check is to discard the majority of the information it contains.
The distinction matters at the level of individual positions, and it matters at the portfolio level when reserve recalibrations aggregate. A lender who monitors systematically has continuous sight of credit migration. A lender who monitors only for breach discovers the problem after the negotiating leverage has shifted.
The Add-Back Problem
The add-back problem makes this more urgent, not less.
In a typical sponsor-backed unitranche today, Adjusted EBITDA exceeds reported EBITDA by 20 to 35 percent at origination. That gap consists of cost synergies, restructuring adjustments, run-rate normalisation, and management overlays — items the sponsor expects will materialise in the 12 to 24 months following close.
The lender's job, quarter by quarter, is to verify that claimed run-rate savings have actually been achieved — and that the add-back headroom is not quietly absorbing real deterioration. Where it is, the covenant test is giving a false all-clear. Trailing EBITDA is stable on paper while the underlying business is under pressure. That is precisely the scenario systematic monitoring is designed to detect.
A Worked Example
Consider a B3/B− rated borrower closing at 5.8x leverage against a 6.5x covenant. Two years in, EBITDA has declined 12 percent. The sponsor requests a $6M restructuring add-back. Without it, trailing leverage crosses the covenant at 6.7x.
The lender now faces a decision with three paths: permit the add-back, negotiate a waiver, or require an equity cure. Each path has a different IRR consequence. Each triggers a different IFRS 9 outcome — and the difference between a Stage 1 hold and a Stage 2 reclassification is not administrative. It affects the ECL provision, the discount rate used in valuation, and the impairment charge in the fund accounts.
The lender who does not have a systematic framework for tracking this is making that decision without the information they are entitled to have. The sponsor, by contrast, has had four quarters to prepare their position.
The Audit Implication
Auditors have noticed. A valuation support file with a line-item discount rate justification but no contemporaneous covenant test documentation is increasingly challenged at audit.
The monitoring record is now part of the valuation evidence. Auditors reviewing a Level 3 fair value assessment expect to see not just the spread and the discount rate, but the credit migration narrative — including what the maintenance tests have been telling the lender quarter by quarter, and how that informed the current mark.
A lender who monitors properly is not doing extra work for the auditor. They are capturing, in real time, the evidence trail that any defensible Level 3 valuation requires. The lender who does not monitor systematically is reconstructing that trail under audit pressure — a materially worse position.
What Systematic Monitoring Looks Like
Systematic covenant monitoring is not complex. It requires four things applied consistently across the portfolio: a defined test schedule aligned to borrower reporting dates; a structured comparison of reported versus adjusted EBITDA with documented add-back ageing; a threshold-based escalation policy (not just breach, but cushion compression); and a written linkage between the monitoring output and the current valuation assumption set.
The last point is the one most often missing. Lenders who monitor but do not connect that monitoring to valuation are doing the work without capturing the benefit. The covenant position should be an explicit input into the discount rate justification — not a footnote, not an afterthought, but a primary driver.
References & Further Reading
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