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Dynamic Threshold Values in Earnings-Based Covenants

Ningzhong Li

University of Texas at Dallas

Florin P. Vasvari

London Business School

Regina Wittenberg Moerman

University of Southern California

June 1, 2015

Journal of Accounting & Economics (JAE), Forthcoming
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 covenants with a tight trend provide a unique signalling 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 tight trend covenants facilitate access to credit for temporarily underperforming borrowers and reduce their loan pricing. Finally, we show that while lenders that enter into tight threshold trend covenant contracts receive weaker covenant protection over the grace period, they benefit from having stronger bargaining power in subsequent periods.

Number of Pages in PDF File: 55

Keywords: syndicated loans, financial covenants, covenant threshold trend, signaling hypothesis, incomplete debt contracting theory

JEL Classification: G17, G21, G32, M41

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Date posted: August 14, 2012 ; Last revised: July 24, 2015

Suggested Citation

Li, Ningzhong and Vasvari, Florin P. and Wittenberg Moerman, Regina, Dynamic Threshold Values in Earnings-Based Covenants (June 1, 2015). Journal of Accounting & Economics (JAE), Forthcoming; Chicago Booth Research Paper No. 12-40. Available at SSRN: http://ssrn.com/abstract=2129230 or http://dx.doi.org/10.2139/ssrn.2129230

Contact Information

Ningzhong Li
University of Texas at Dallas ( email )
2601 North Floyd Road
Richardson, TX 75083
United States
Florin P. Vasvari
London Business School ( email )
Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom
Regina Wittenberg Moerman (Contact Author)
University of Southern California ( email )
Los Angeles, CA 90089
United States
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