Performance Pricing in Debt Contracts

Abstract

In this paper we examine the decision to include performance pricing in lending contracts and we examine how that decision affects the spread that is charged on the loan. We find that contracts are more likely to include this feature when moral hazard costs are expected to be higher, uncertainty about changes in borrower credit risk is greater, managers willingness to bear increased risk is lower, adverse selection problems are larger, and when there are likely to be more renegotiation costs. Consistent with performance pricing reducing these problems, we find that after controlling for a selectivity correction and other factors known to affect loan spreads, the spread charged on a loan is 117 basis points lower when the price of the loan varies with the performance of the borrower. These results suggests that performance pricing provides a mechanism in addition to other contract features, such as covenants and loan maturity, that can be used to address some of the problems associated with debt.

Keywords: accounting, debt, leverage, performance, prcing, interest rate, default, accounting choice, Watts, Zimmerman, earnings management, earnings, efficient contracting, contracting, positive accounting

JEL Classification: G21, G30, G39, M41, M43