Agency Costs, Information, and the Structure of Corporate Debt Covenants
45 Pages Posted: 17 Mar 2012
Date Written: November 17, 2011
Private debt contracts tend to have covenants that restrict future investment, restrict capital structure decisions, or impose thresholds for cash flows or other performance measures. While previous studies have demonstrated a relationship between firm characteristics and the overall strictness of loan contracts, few studies have examined why covenants are written on a range of accounting variables and what determines their selective use. Using a model of firm investment where firms face uncertain cash flows and investment opportunities, we characterize the conditions under which it is optimal for a debt contract to specify a restriction on investment or to specify a minimum cash flow realization. Consistent with this model, we find that the application of covenants based on these variables is not necessarily monotonic in firm risk. While the financially riskiest firms tend to employ capital expenditure covenants, cash flow and net worth covenants are most common among moderately risky firms with greater profitability and firms with stronger banking relationships. The results also highlight the importance of debt covenants in both mitigating agency frictions and maximizing the value of future private information. Additionally, they shed light on the heterogeneity in covenant application and help explain how firms make the trade-off between control over investment and the ex-post cost of financing.
Keywords: covenants, debt, information, bank loans
JEL Classification: G32, G33
Suggested Citation: Suggested Citation