How Does Financing Impact Investment? The Role of Debt Covenants

Abstract

We identify a specific channel (debt covenants) and the corresponding mechanism (transfer of control rights) through which financing frictions impact corporate investment. Using a regression discontinuity design, we show that capital investment declines sharply following a financial covenant violation, when creditors use the threat of accelerating the loan to intervene in management. Further, the reduction in investment is concentrated in situations where agency and information problems are relatively more severe, highlighting how the state contingent allocation of control rights can help mitigate investment distortions arising from financing frictions.

Keywords: Investment, Covenant, Debt, Contracts, Renegotiation, Default, Control Rights

JEL Classification: G31, G33, G21, G32