Post by Hans Bonde Christensen on Feb 20, 2011 5:58:13 GMT 4
Capital Versus Performance Covenants in Debt Contracts
Hans Bonde Christensen
University of Chicago - Booth School of Business
Valeri Nikolaev
University of Chicago - Booth School of Business
January 25, 2011
Chicago Booth Research Paper No. 11-06
Abstract:
We study the contracting role of financial covenants classified into two types. We argue that capital covenants control agency problems by maintaining equity capital sufficient to align debtholder-shareholder objectives ex ante, whereas performance covenants serve as tripwires that address agency problems by facilitating control transfers and re-negotiations ex post. We find that capital and performance covenants are used in different contracting environments. Performance covenants are strong predictors of future contract re-negotiations, in line with their tripwire role, while this is not the case for capital covenants. We also find that restrictions on managerial actions are less commonly used in conjunction with capital covenants, in line with their incentive-alignment role. We further predict and find that performance covenants, serving as tripwires, are chosen when accounting information is contractible, i.e., descriptive of credit quality, while the opposite holds for capital covenants. The results shed light on how accounting information properties affect covenant package design.
papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1747909_code753937.pdf?abstractid=1747909&mirid=2
Hans Bonde Christensen
University of Chicago - Booth School of Business
Valeri Nikolaev
University of Chicago - Booth School of Business
January 25, 2011
Chicago Booth Research Paper No. 11-06
Abstract:
We study the contracting role of financial covenants classified into two types. We argue that capital covenants control agency problems by maintaining equity capital sufficient to align debtholder-shareholder objectives ex ante, whereas performance covenants serve as tripwires that address agency problems by facilitating control transfers and re-negotiations ex post. We find that capital and performance covenants are used in different contracting environments. Performance covenants are strong predictors of future contract re-negotiations, in line with their tripwire role, while this is not the case for capital covenants. We also find that restrictions on managerial actions are less commonly used in conjunction with capital covenants, in line with their incentive-alignment role. We further predict and find that performance covenants, serving as tripwires, are chosen when accounting information is contractible, i.e., descriptive of credit quality, while the opposite holds for capital covenants. The results shed light on how accounting information properties affect covenant package design.
papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1747909_code753937.pdf?abstractid=1747909&mirid=2