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
July 26, 2013
Chicago Booth Research Paper No. 12-40
In this study, we examine the role of changing covenant threshold values in syndicated loan agreements. We find that 45% of loans specify changing covenant thresholds in earnings-based covenants, which are the most frequently used financial covenants in syndicated loans. These changing thresholds typically become tighter over the life of a loan. We hypothesize and find that this tight threshold trend reflects a contingent allocation of control rights between borrowers and lenders. Lenders relax the lending criteria for underperforming borrowers at a loan’s origination, providing lower initial covenant thresholds for a temporary “grace period”, but then require increasingly demanding performance thresholds over the loan’s duration that allow them to obtain stronger control rights. Our findings corroborate the incomplete debt contracting theory of Aghion and Bolton (1992) and Dewatripont and Tirole (1994) and shed light on the use of earnings-based covenants in the ex-ante allocation of control rights.
Number of Pages in PDF File: 58
Keywords: syndicated loans, financial covenants, covenant threshold trend, creditor control rights, incomplete debt contracting theory
JEL Classification: G17, G21, G32, M41working papers series
Date posted: August 14, 2012 ; Last revised: August 1, 2013
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