Financial Covenants and Related Contracting Processes in the Australian Private Debt Market: An Experimental Study

Abstract:     
Private debt markets are characterised by covenant restrictive but renegotiation-flexible debt contracts as financial intermediaries lending in private debt markets have a comparative advantage over investors in public debt markets in offering such contracts. The two research questions investigated in this paper are "Whether several borrower-and contract-specific variables determine the restrictiveness of financial covenants in private debt contracts?" and "Whether several borrower-and contract-specific variables are associated with loan officers decisions to waive technical default on financial covenants?" Two behavioural experiments involving loan officers examined these contracting processes in the Australian private debt market. The first experiment examined whether certain variables determine the restrictiveness of financial covenants in private debt contracts. Management reputation and security were found to be associated with the number and tightness of financial covenants, whilst high financial risk was associated with increased tightness, but not the number, of such covenants. The effect of the interaction, management reputation x security, was also significant. The second experiment examined the association between certain variables and the likelihood of loan officers waiving technical default on financial covenants. Low financial risk, security and defaults caused solely by a change in accounting standards were found to be associated with the likelihood of the default being waived.

These are the first behavioural experiments examining these debt contracting processes reported in the literature and the paper contributes in several ways. First, the methodology allows comparisons with findings of prior research from a new perspective. Second, the methodology enabled the investigation of the effect of management reputation on the restrictiveness of covenants: an important addition to the literature given its prominence in professional banking writings. Third, the experimental setting facilitated controlling the investment opportunity set when studying the responses to technical default thereby overcoming a limitation of the main prior study in this area (Chen and Wei, 1993).

Keywords: Debt Covenants, Private Debt Markets, Debt Contracting

JEL Classification: M41, G32, C91

Accepted Paper Series