Signaling, Financial Constraints, and Performance Sensitive Debt
37 Pages Posted: 3 Sep 2012 Last revised: 2 Aug 2013
Date Written: August 31, 2012
This paper examines how good borrowers use the design of performance sensitive debt contracts to alleviate financial constraints. I show that borrowers use a convex pricing grid (i.e., a contract where the increase in the loan spread following a decline in performance exceeds the decrease in the spread following a performance improvement) to signal their unobservable creditworthiness and receive better bank loan terms. I find that constrained firms that use convex pricing grids receive loans that are 21-28% larger with a spread that is 31-37 basis points lower than observationally similar borrowers that use fixed spread loans. Consistent with the notion that a costly signal should positively correlate with future financial health, I find that constrained borrowers that use a loan with a convex pricing grid are one third less likely to experience financial distress during the term of their loans.
Keywords: performance sensitive debt, signaling, security design, financial contracting, financial constraints
JEL Classification: G30
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