When Are Financial Covenants Relevant?
53 Pages Posted: 17 Mar 2020 Last revised: 6 Jan 2021
Date Written: February 28, 2020
This paper shows that financial covenants have no value for creditors of highly levered firms, because an attempt to enforce their rights in technical default would result in a lower payoff than continued operations under shareholders' control. This explains the widespread use of cov-lite loans by junk firms. By contrast, for investment-grade firms tightly set covenants allow creditors to demand full repayment while the firm is still solvent. This ensures that creditors sustain no loss regardless of the underlying default probability, mitigating their concerns about the firm's financial health and alleviating adverse selection in lending. We show that the optimal strictness of financial covenants is hump-shaped in the firm's leverage.
Keywords: Corporate Loans; Covenants; Covenant strictness; Cov-lite
JEL Classification: G23, G32
Suggested Citation: Suggested Citation