Dynamic Threshold Values in Earnings-Based Covenants

Abstract:     
In this study, we examine an important characteristic of financial covenants that has not been explored by prior research - the covenant threshold values that change over the life of the debt agreement. We find that 45% of syndicated loan contracts specify changing covenant thresholds in earnings-based covenants and that these thresholds typically become tighter over the life of the loan. We document that covenants with a tight threshold trend are included in the loan contracts of more risky borrowers. We also find that a tight threshold trend reveals information about the borrower’s future performance. It predicts lower profitability, higher leverage and lower interest coverage ratios following the loan issuance and is associated with future negative analyst earnings forecast revisions. We further find that by increasing the probability of covenant violations and renegotiations and by decreasing the time period up to the first covenant renegotiation, a tight threshold trend facilitates the transfer of control rights to lenders. Our findings highlight the importance of dynamic covenant threshold values and suggest that a tight trend in these values is informative about a borrower's future performance and enhances financial covenants’ efficiency as “trip-wires” in debt contracts.

Number of Pages in PDF File: 63

Keywords: syndicated loans, financial covenants, covenant threshold trend, covenant violations, renegotiation, lenders’ private information, lenders’ bargaining power, creditor control rights

JEL Classification: G17, G21, G32, M41

working papers series