Dynamic Threshold Values in Earnings-Based Covenants

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 covenants with a tight trend provide a unique signalling mechanism that meets the needs of borrowers that experience an inferior financial performance at loan initiation but expect future performance improvements. Specifically, we find that these covenants provide underperforming borrowers with a grace period by requiring less restrictive initial thresholds. At the same time, they allow these borrowers to credibly convey information to lenders about their future prospects via gradually more demanding subsequent thresholds. Our empirical evidence also suggests that tight trend covenants facilitate access to credit for temporarily underperforming borrowers and reduce their loan pricing. Finally, we show that while lenders that enter into tight threshold trend covenant contracts receive weaker covenant protection over the grace period, they benefit from having stronger bargaining power in subsequent periods.

Keywords: syndicated loans, financial covenants, covenant threshold trend, signaling hypothesis, incomplete debt contracting theory

JEL Classification: G17, G21, G32, M41