Why prepaying to cure a covenant costs eleven times a deposit
The ratio between the two cures is independent of how deep the income decline is, and entirely dependent on the covenant level and the amortisation schedule.
A borrower breaches a 1.20× coverage covenant after a 20 per cent fall in income.
It can cure with a deposit or by prepaying principal. The deposit costs
233,192. The prepayment costs 2,602,535 — 11.2 times as much. That
ratio is not a feature of this loan, and it is not a feature of the size of the decline
either. It is 1/(k·c), and both letters are negotiated at closing.
Practitioners get the first half of this right by instinct: the ratio between the two cures
does not depend on how bad things get. What almost nobody says is the second half, which is that
it depends entirely on the coverage covenant and the amortisation schedule — the two terms
a borrower actually negotiates, usually without knowing this is one of the things being
negotiated.
The loan, and the ladder it sits under
A stabilised asset appraised at 62 million, financed at 60 per cent loan to value on a
thirty-year schedule. The mortgage constant is 7.467 per cent, so debt service is 2,777,660 and coverage
today is 1.395 times. Debt yield is 10.42%. The covenant ladder has four rungs.
Trigger
NOI required
Decline from today
Coverage 1.20× — cash trap
3,333,192
-14.0%
Debt yield 8.50% — cash trap
3,162,000
-18.4%
Coverage 1.10× — cash sweep
3,055,426
-21.2%
Coverage 1.05× — event of default
2,916,543
-24.7%
A 37,200,000 loan at 6.35% over 30 years, 3,875,000 of net operating income.
The two cures, priced
Income falls 20 per cent, to 3,100,000. The coverage test now fails. A deposit cure tops up the
numerator: put in enough cash that the ratio reads 1.20× again. A prepayment cure shrinks
the denominator: repay principal until the reduced debt service is covered.
At a 20% income decline
Amount
Income after the decline
3,100,000
Cure by deposit — top the coverage ratio back to 1.20×
233,192
Cure by prepayment — shrink the loan until 1.20× holds
2,602,535
The ratio between them
11.2×
Two ways to cure the same breach. One costs eleven times the other.
Both cures fix exactly the same breach and leave the lender in exactly the same covenant
position. One costs eleven times the other. Which of the two the loan agreement gives you is
therefore worth roughly 2,369,343 in this scenario, and the clause that decides it usually runs to two
sentences.
Why the ratio does not move with the decline
Write both cures out. The deposit is k·DS − I. The prepayment is
L − I/(k·c), because the loan must shrink until k times the new
debt service equals income, and debt service is the balance times the constant. Substitute
DS = L·c and the income term cancels out of the ratio:
prepayment / deposit = 1 / (k · c)
Income decline
Deposit cure
Prepayment cure
Ratio
-15%
39,442
440,194
11.16
-18%
155,692
1,737,599
11.16
-20%
233,192
2,602,535
11.16
-25%
426,942
4,764,877
11.16
-30%
620,692
6,927,218
11.16
The ratio does not move. That is the half the instinct gets right.
But it depends entirely on two things you negotiate
Neither k nor c is a market fact. The coverage covenant is negotiated line
by line. The mortgage constant is set by the amortisation schedule, which is negotiated in the
same session — and usually traded away for a few basis points on the rate.
Amortisation
k = 1.15
k = 1.20
k = 1.25
k = 1.30
Interest only
13.69
13.12
12.60
12.11
30 years
11.65
11.16
10.71
10.30
25 years
10.88
10.43
10.01
9.63
20 years
9.84
9.43
9.05
8.70
The ratio 1/(k·c), at four amortisation schedules and four covenant levels.
From 8.70 times to 13.69 times across that grid. A borrower who concedes ten years of
amortisation to shave the coupon — twenty-five years instead of thirty-five, say —
has also cut the leverage of its deposit cure by roughly a fifth, and nobody prices that at the
table. It costs nothing to compute before the session and it is unrecoverable afterwards.
And the cheap cure has an expiry date
A deposit cure only works while the coverage test is the binding one. There is a second
trigger on the ladder — the debt yield trap at 8.50% — and a deposit does nothing for
it, because debt yield has no debt-service term to top up. Income is income.
The coverage trap fires at a 14.0% income decline. The debt yield trap fires at 18.4%. Between
them is a window of 4.42 points of income decline in which the cheap cure works,
and outside it only a prepayment does.
Debt yield covenant
Fires at an income decline of
Window, points
8.00%
-23.2%
9.22
8.25%
-20.8%
6.82
8.50%
-18.4%
4.42
8.75%
-16.0%
2.02
9.00%
-13.6%
-0.38
Every point of debt yield covenant conceded moves the second trigger.
So the deposit cure has the shape of an option that expires exactly when it acquires value:
cheap while the decline is shallow enough that a sponsor could probably have funded the shortfall
anyway, unavailable once the decline is deep enough to hurt. That does not make it worthless
— a four-point window is real and most income declines are shallow — but it makes its
value bounded, and the bound is 1,910,586, computable on the day the loan closes.
A debt yield covenant at 8.00 rather than 8.50 more than doubles the range over which the cheap
cure works, which is the negotiation that number argues for.
One more thing worth checking in your own paper
It is easy to size a cure against the wrong threshold. Origination tests and covenant
thresholds are different numbers that look alike: this loan was sized at a 9.00 per cent
debt yield and its covenant trap is at 8.50. Curing back to 9.00 restores a test the
loan does not impose.
Income decline
Debt yield
Cure to 9.00%
Cure to 8.50%
Overshoot
-18%
8.54%
1,894,444
0
no breach to cure
-20%
8.33%
2,755,556
729,412
3.78×
-22%
8.12%
3,616,667
1,641,176
2.20×
-25%
7.81%
4,908,333
3,008,824
1.63×
-30%
7.29%
7,061,111
5,288,235
1.34×
9.00 per cent is the origination sizing test. The covenant is 8.50.
Read the first row. At an 18 per cent decline the debt yield is 8.54% — above the
8.50 per cent trap. There is no breach at all, and a cure sized to the origination test prepays
1,894,444 to fix it. At a 20 per cent decline, where there is a real breach, curing to 9.00 rather than
8.50 prepays 3.78 times what the covenant requires.
Three lines to add to a term sheet review
Compute 1/(k·c) for the loan in front of you and write it on the page: it is the
multiplier on every future cure decision and it takes one formula. Compute the window between the
coverage trigger and the debt yield trigger, because that is the range over which the cheap cure
exists. And when a cure is proposed, check which threshold it restores — the covenant, or
the test the loan was sized against.
None of these is a modelling exercise. They are three numbers that exist the day the loan
closes and are usually computed, if at all, on the day they stop being useful.
The workbook behind this article
Every figure above is a live formula in the companion file for
How to Read a Real Estate Loan Agreement, which also holds the covenant ladder, the cure window at every debt yield level, and the extension and refinancing tests. It is free, and it needs no account and
no email address.
Should corporate debt be fixed or floating?78.1818 per cent of gross debt fixed, and a net floating exposure after cash of -608,000.00 — the proportion, not the instrument.
Does an undrawn revolver count as liquidity?67.4567 per cent of the headroom, and it leaves at a fall in annual revenue of 8.4127 per cent — not the 13.3333 per cent the board deck implies.
Does supply chain finance count as debt?66,049,315 released, and leverage of 2.7622× or 3.1362× depending on which balance the test is asked of — the second is a breach at today's EBITDA.
How do you set a minimum cash balance?Three components, 124,596,281 in total — and the double count that turns a margin of 27,403,719 into an apparent shortfall of -3,988,281.
Is a 2/10 net 60 discount worth taking?An annualised 14.8980 per cent against a revolver at 4.50 per cent — worth 5,471,890 a year, and 0.3132 turns of reported leverage.
At what wealth does a family office pay?A five-person office costs the same $2,442,000 at $100m as at $2bn. Against a tiered multi-family schedule the two curves cross exactly once.
Does the fulcrum move with enterprise value?A worked capital structure at three enterprise values. The break migrates from the first lien to the subordinated notes without a single document changing.
How many companies does a reserve pool defend?Holding pro rata to the Series D costs $14.76m per company. A $40m reserve defends 2.71 of forty — and 61 per cent of the cost is the last round.
How much room a 1.15x downside actually leaves79 basis points of margin. The leverage covenant fails first, five basis points before the coverage covenant the chapter reports on, and 4.6 per cent of EBITDA is the whole cushion.
How the GP catch-up is actually solvedMost write-ups state the catch-up formula then hardcode the answer. Set it as a solve and it moves on its own when the carry rate does.
Six ways to state the same fund's return7.12 per cent, 18.04 per cent, or 1.323 times the public market — one fund, one set of flows. The eleven-point gap is the valuation, and it is not cash.
The IRR at which a closed-ended fund merely tiesA drawdown fund advertising 13.25 per cent ties an evergreen netting 8.64. On committed rather than called capital, 78.7 per cent of the edge vanishes.
The month a remediation trigger has to be armed byMonth 8, on a one-year window and a 14-week hiring lead time. The date is 12W − L/4.33 and holds for any portfolio size — the book only changes the euros.
Two routes to the same NAVFive findings in one quarter-end close, and not one of them was a modelling error. Every one was a control that did not exist.
What a CBAM certificate buffer costs to holdCarry and protection are both linear in the buffer, so the break-even probability is identical at 5 per cent and at 30 — and 2027 costs exactly twice 2026.
What a clawback actually collateralises24 million recovers 13.20 net of tax and 7.20 is escrowed. The rule is e ≥ 1 − t, and every euro won on the tax clause lands uncollateralised.
What a co-investment programme actually saves37 basis points, and a 22.8 per cent total-loss rate erases it. At the usual per-deal cap a single failure is 37 per cent of the annual cohort.
What a diligence exercise actually recoversEighteen basis points is only the part that reaches the yield. Three of the four instruments never do, and the exercise is worth thirty-one.
What a follow-on reserve is actually worth0.019 turns under plain dilution, 0.285 under pay-to-play. The optimum is a property of the shareholders’ agreement, not of the portfolio.
What a lease mark-to-market is actually worth5,788,000 becomes 807,365 once the over-market stream, the expiry dates and the cost of re-letting are priced — and nothing at all below a 43.7 per cent renewal rate.
What a minimum payment actually does£81.53 leaves the account and £20.46 reaches the debt. On minimums alone the set clears in 258 months and repays 1.78 times what was borrowed.
What a month of delay costs in an enforcement463,000 euros of present value a month. No single error about enforcement, and no pair of errors, moves the indifference point from 58.7 cents to the 72 on the table.
What a pro rata cheque actually costsDefending costs 1.25 times the initial cheque across two rounds, not more in each — and below a 521 exit the follow-on dollars come back worth less than they cost.
What a subscription line does to the IRR20 per cent becomes 38.41 on the same asset while the multiple falls. Two dollars of interest buys 18.4 points, and the longer the line runs the cheaper each point gets.
What one point of fees actually costsOne point on the annual charge turns 738,846 into 567,961 over forty years — 23 per cent of the pot, and 2.43 of wealth lost per 1 of fee.
When the promote stops clearingCarried interest is not proportional to performance near the hurdle. It is a step function, and $2m of headroom is what stands between a promote and none.
Why a secondaries bid-ask gap has no zoneThe seller’s floor and the buyer’s ceiling are one formula at two rates. At equal required returns the zone is exactly zero — here it is 11.02 points apart.
Why refining a due diligence rubric makes it weakerThree of twelve managers carry a terminal flaw and the average approves all three. Splitting eight domains into sixteen makes it easier to hide, not harder.
This note is drawn from How to Read a Real Estate Loan Agreement. The book is on Amazon.
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