Dynamic Threshold Values in Earnings-Based Covenants
University of Texas at Dallas
Florin P. Vasvari
London Business School
Regina Wittenberg Moerman
University of Chicago - Booth School of Business
April 10, 2014
Chicago Booth Research Paper No. 12-40
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 this tight trend in covenant threshold values provides an important signalling mechanism for borrowers experiencing an inferior financial performance at loan initiation but that expect future performance to significantly improve. We show that the initial threshold values in tight trend covenants are less restrictive relative to the threshold values in constant threshold covenants, thus endowing underperforming borrowers with a grace period at loan initiation during which they can enhance their financial performance. At the same time, the tight trend allows these borrowers to credibly signal to lenders their future prospects by committing to more demanding subsequent thresholds. We also show that while lenders provide borrowers with a grace period at loan initiation, they obtain stronger control rights if borrowers do not improve their performance sufficiently to meet the increasingly demanding threshold. The tight trend feature thus allows a dynamic allocation of control rights between borrowers and lenders that cannot be achieved by a covenant structure with constant thresholds.
Number of Pages in PDF File: 53
Keywords: syndicated loans, financial covenants, covenant threshold trend, signaling hypothesis, incomplete debt contracting theory
JEL Classification: G17, G21, G32, M41working papers series
Date posted: August 14, 2012 ; Last revised: April 15, 2014
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