Private Lenders’ Use of Analyst Earnings Forecasts When Establishing Debt Covenant Thresholds
55 Pages Posted: 13 Feb 2018
Date Written: January 2018
We examine whether lenders use analyst forecasts of the borrowing firm’s earnings when establishing covenant thresholds in private debt contracts. We find greater proximity between the analysts’ consensus earnings forecast and the future earnings performance required by the contract among borrowers whose analysts have historically issued accurate earnings forecasts, consistent with our hypothesis that lenders use analyst earnings forecasts when establishing debt covenant thresholds. These results are robust to firm and year fixed effects as well as an instrumental variable approach that addresses potential correlated omitted variables. We also find that the likelihood that the borrower violates a debt covenant following a decline in creditworthiness is increasing in the extent to which the debt covenant threshold is set closer to analyst expectations, suggesting that lenders’ use of analyst research increases the effectiveness of debt covenants in transferring contingent control rights following declines in creditworthiness. Our results provide new evidence on the role of sell-side analysts in debt contracting and inform the literature on the information used by lenders when establishing debt covenant thresholds.
Keywords: Analysts, earnings forecasts, debt covenants
JEL Classification: M40, M41, G20, G21
Suggested Citation: Suggested Citation