Weak Credit Covenants

52 Pages Posted: 9 Aug 2018 Last revised: 18 Jul 2019

See all articles by Victoria Ivashina

Victoria Ivashina

Harvard University; National Bureau of Economic Research (NBER)

Boris Vallee

Harvard Business School - Finance Unit

Date Written: May 28, 2019

Abstract

Using novel data on 1,240 credit agreements for leveraged loans, we investigate sources of contractual complexity and their economic rationale. We show that while restrictions on the use of collateral, issuance of new debt, payments to shareholders, asset sales, and affiliate transactions are widespread, clauses that weaken these negative covenants are as frequent. We propose a simple way to account for contractual weakness. These measures are key to understanding the market-wide price reaction that followed a high-profile court case, where the borrower used such contractual elements to dilute existing creditors. Leveraged buyouts, and especially those backed by sponsors with credit market expertise, have loan agreements with the most weakened negative covenants. At the same time, a larger non-bank funding of a loan, and in particular larger engagement by securitization vehicles, is conducive to weaker contractual terms, which translate into modestly higher issuance spreads. Our findings are consistent with sophisticated borrowers catering to a reaching for yield phenomenon by exploiting contractual complexity.

Keywords: Loan Contracts, Debt Covenants, Creditor Governance, Leveraged Buyouts

JEL Classification: G14, G23, G32

Suggested Citation

Ivashina, Victoria and Vallee, Boris, Weak Credit Covenants (May 28, 2019). Available at SSRN: https://ssrn.com/abstract=3218631 or http://dx.doi.org/10.2139/ssrn.3218631

Victoria Ivashina

Harvard University ( email )

Harvard Business School
Baker Library 233
Boston, MA 02163
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Boris Vallee (Contact Author)

Harvard Business School - Finance Unit ( email )

Boston, MA 02163
United States

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