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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 Chicago - Booth School of Business

April 10, 2014

Chicago Booth Research Paper No. 12-40

Abstract:     
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, M41

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Date posted: August 14, 2012 ; Last revised: April 15, 2014

Suggested Citation

Li, Ningzhong and Vasvari, Florin P. and Wittenberg Moerman, Regina, Dynamic Threshold Values in Earnings-Based Covenants (April 10, 2014). 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 Chicago - Booth School of Business ( email )
1369 E. Hyde Park Blvd
Chicago, IL 60637
United States
773-263-0101 (Phone)
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