What Is an Equity Cure and How Does It Work?

An equity cure is a contractual provision in loan agreements, particularly in leveraged finance, allowing a borrower to inject new equity capital into their company. This injection remedies a breach of financial covenants and prevents a technical default on debt obligations. Its aim is to provide a lifeline, offering a structured path for a company to restore compliance with its lending terms rather than facing immediate and severe consequences. It offers flexibility to businesses experiencing temporary financial strain, helping them rectify their financial standing through new capital investment.

Understanding Financial Covenants and Default

Financial covenants are specific conditions in loan agreements, requiring borrowers to maintain certain financial metrics or ratios. These covenants act as an early warning system for lenders, providing periodic snapshots of the borrower’s financial health. Common examples include the Debt Service Coverage Ratio (DSCR), which measures a company’s ability to repay debt from operating income, and the Total Leverage Ratio, which assesses debt levels relative to earnings. Other frequently used covenants involve maintaining a minimum Net Worth or a specific Fixed Charge Coverage Ratio.

Lenders incorporate these covenants to protect their investment, mitigate risk, and ensure the borrower’s capacity to repay the loan. These agreements also provide financial discipline for the borrower, preventing actions that could increase risk or jeopardize repayment. If a borrower fails to meet one of these predefined financial metrics, it constitutes a “technical default.”

A technical default differs from a payment default; it means the borrower has violated a non-financial condition of the loan agreement, such as failing to maintain a required ratio, even if all payments are being made on time. While the company might still be solvent, a covenant breach can trigger serious repercussions. Lenders have the right to declare the entire loan immediately due and payable, impose higher interest rates, or restrict further access to credit facilities. An equity cure becomes a mechanism to address these breaches, allowing the borrower to avoid such consequences and maintain the loan agreement.

The Mechanics of an Equity Cure

An equity cure involves a direct infusion of capital into the borrower company, provided by its shareholders, a parent company, or a private equity sponsor. This new capital takes the form of a cash injection in exchange for new equity shares. In some cases, loan agreements may permit the injection to be structured as subordinated debt, provided it is treated as equity for covenant calculations.

The objective of this capital injection is to improve the company’s financial metrics to bring them back into compliance with the breached financial covenant. For instance, if a leverage ratio (debt-to-EBITDA) is breached, the new equity can reduce net debt (if used for debt repayment) or enhance the company’s earnings before interest, taxes, depreciation, and amortization (EBITDA), thereby improving the ratio. An equity cure also directly increases the company’s equity base, which helps cure a net worth covenant breach or improve debt-to-equity ratios.

From an accounting perspective, an equity injection increases shareholders’ equity on the balance sheet, often recorded under “common stock” or “additional paid-in capital.” This strengthens the company’s capital structure and can improve solvency ratios. For covenant testing purposes, the loan agreement specifies how this new capital is treated; often, it is retroactively applied to the period of the breach, effectively “retesting” the covenant as if the equity had been present then. While the injected cash becomes part of the company’s general working capital, available for operations or debt reduction, the equity injection itself is generally considered a capital contribution and not taxable income for the company.

Important Provisions for Equity Cures

Equity cure provisions in loan agreements are negotiated, outlining specific terms and limitations. A common limitation is the frequency of cures, allowing a certain number over the life of the loan, often ranging from two to four times over a typical five-to-seven-year loan term. Agreements often restrict cures to no more than one per fiscal year or within consecutive periods, preventing their use to mask ongoing underperformance.

The amount of equity that can be injected is also regulated. The cure amount must be sufficient to remedy the breach, meaning it must bring the specific financial metric back into compliance. Loan agreements may also specify a maximum amount that can be injected for a cure, often capped as a percentage of the required cure or a fixed sum, and typically, any excess capital cannot be saved for future cures.

Borrowers are usually required to execute the cure within a specified period, such as 30 to 60 days, after the end of the fiscal quarter in which the covenant breach was identified. The treatment of the cure capital is also detailed; for covenant calculation, the injected equity is often deemed to retroactively adjust the financial statements for the breached period. However, lenders sometimes include “no-cash-out” provisions, ensuring the equity cannot be immediately distributed back to the providers, reinforcing that the funds are for the company’s benefit and not merely a temporary accounting adjustment.