Abstract
We examine the role of dynamic covenant threshold values in syndicated loan agreements. We document that 45% of syndicated loans specify dynamic covenant thresholds in earnings-based covenants and that these changing thresholds typically become tighter over the life of a loan. We find that covenants with a tight trend provide an important signaling mechanism that meets the needs of borrowers that experience an inferior financial performance at loan initiation but expect future performance improvements. Specifically, we find that these covenants provide underperforming borrowers with a grace period by requiring less restrictive initial thresholds. At the same time, they allow these borrowers to credibly convey information to lenders about their future prospects via gradually more demanding subsequent thresholds. Our empirical evidence also suggests that while lenders entering into tight threshold trend covenant contracts receive weaker covenant protection over the grace period, they benefit from having stronger control rights in subsequent periods.
| Original language | English (US) |
|---|---|
| Pages (from-to) | 605-629 |
| Number of pages | 25 |
| Journal | Journal of Accounting and Economics |
| Volume | 61 |
| Issue number | 2-3 |
| DOIs | |
| State | Published - Apr 1 2016 |
Funding
We appreciate the helpful comments of an anonymous referee, the editor (Wayne Guay), Anne Beatty (discussant), Phil Berger, Lamont Black (discussant), Doug Diamond, Scott Liao (discussant), Haresh Sapra, Doug Skinner, Amir Sufi, Scott Richardson, Michael Roberts, Vikrant Vig, Andrew Winton and Franco Wong (discussant), participants at the 2013 AAA annual meetings, the 2013 MIT Asia Conference in Accounting, the 49th Bank Structure Conference at the Chicago Fed, the 2015 Midwest Finance Association Meetings, the University of Minnesota Empirical Conference and seminar participants at London Business School, Tilburg University, the University of Chicago, the University of Michigan and the University of Southern California. We thank Greg Nini, David Smith and Amir Sufi for covenant violations data and Yiwei Dou for covenant renegotiations data. We also thank Ying Huang, Yun Lou, Yu Xie and Sundipika Wahal for excellent research assistance. We gratefully acknowledge the financial support of the AXA Research Fund, the London Business School RAMD Fund, the University of Chicago Booth School of Business, and the University of Texas at Dallas. Regina Wittenberg-Moerman also gratefully acknowledges the financial support of the Neubauer Family Fellowship. This paper was previously circulated under the title “The Information Content of Threshold Values in Earnings-Based Covenants.”
Keywords
- Covenant threshold trend
- Financial covenants
- Incomplete debt contracting theory
- Signaling hypothesis
- Syndicated loans
ASJC Scopus subject areas
- Accounting
- Finance
- Economics and Econometrics