Abstract

http://ssrn.com/abstract=1747909
 
 

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Capital Versus Performance Covenants in Debt Contracts


Hans Bonde Christensen


University of Chicago - Booth School of Business

Valeri V. Nikolaev


University of Chicago - Booth School of Business

September 27, 2011

Chicago Booth Research Paper No. 11-06

Abstract:     
Building on contracting theory, we argue that financial covenants control the conflicts of interest between lenders and borrowers via two different mechanisms. Capital covenants control agency problems by aligning debtholder-shareholder interests. Performance covenants serve as tripwires that limit agency problems via the transfer of control to lenders in states where the value of their claim is at risk. Companies trade off these mechanisms. Capital covenants impose costly restrictions on capital structure, while performance covenants require contractible accounting information to be available. Consistent with these arguments, we find that the use of performance covenants relative to capital covenants is positively associated with (1) the financial constraints of the borrower, (2) the extent to which accounting information portrays credit risk, (3) the likelihood of contract renegotiation, and (4) the presence of contractual restrictions on managerial actions. Our findings suggest that accounting-based covenants can improve contracting efficiency in two conceptually different ways.

Number of Pages in PDF File: 57

Keywords: accounting-based covenants, private debt, financial contract design

JEL Classification: M40

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Date posted: January 26, 2011 ; Last revised: September 26, 2011

Suggested Citation

Christensen, Hans Bonde and Nikolaev , Valeri V., Capital Versus Performance Covenants in Debt Contracts (September 27, 2011). Chicago Booth Research Paper No. 11-06. Available at SSRN: http://ssrn.com/abstract=1747909

Contact Information

Hans Bonde Christensen
University of Chicago - Booth School of Business ( email )
5807 South Woodlawn Avenue
Chicago, IL 60637
United States

Chicago Booth School of Business Logo

Valeri V. Nikolaev (Contact Author)
University of Chicago - Booth School of Business ( email )
5807 South Woodlawn Avenue
Chicago, IL 60637
United States
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