Determinants of the Usefulness of Inside Debt in Debt Contract Design

Abstract

We provide evidence on how borrowers’ credit constraints and distress risk affect the weight creditors place on inside debt when designing debt contract terms, focusing on the inclusion and strictness of covenants and the cost of debt. We find evidence that creditors place less weight on inside debt when borrowers have credit constraints, consistent with a shift in bargaining power to lenders, and when firms experience financial distress, consistent with increased agency costs when bankruptcy is more probable. Our evidence is stronger for the cost of debt than for covenant inclusion or strictness. We augment our results by leveraging two plausibly exogenous shocks to firms’ credit constraints and distress risk: the Global Financial Crisis and industry-level shocks to demand. Consistent with our primary tests, we detect reduced weight on inside debt for debt contracting during these events.