Balance Sheet Debt Covenants and Seasoned Equity Offerings

Abstract

Synopsis The research problem This study examined the effect of having debt contracts that contain balance sheet covenants on the decision to make seasoned equity offerings (SEOs). Motivation Prior studies examined the determinants of equity issuance without considering private debt contracts that contain balance sheet covenants. Generally, firms are not restricted from stock issuance when they have financial debt covenants. This might motivate firms to make SEOs when they are more susceptible to balance sheet debt covenant violations. Making SEOs increases firms’ equity capitals in the short term and, therefore, has the direct effect of improving balance sheet covenants in the current period. This effect motivated this study to examine whether firms are more likely to conduct SEOs when their debt contracts include more-restrictive balance sheet covenants. The test hypothesis The hypothesis of the study is in the null form, which states that balance sheet covenant restrictiveness is unrelated to the probability of conducting SEOs. Target population The target population includes shareholders, debtholders, and firm managers. Adopted methodology Panel data estimation was used, specifically, the fixed effects model. Analyses The empirical analysis was conducted on a unique sample of UK listed firms with private debt covenants that is hand-collected from annual reports. Equity issuance in the sample is based on private placements, which are a common type of SEO in the UK. The restrictiveness of balance sheet-based covenants is defined as the number of balance sheet covenants in a loan contract or the tightness of net worth covenant slack. Findings The results show that balance sheet covenant restrictiveness is positively associated with the probability of conducting SEOs through private placements. The baseline result is robust to the application of a number of the controls often used in the literature, including cash shortage, the use of balance sheet covenants in the previous loan contract, earnings management, and the quality of external governance. It is also robust to excluding the financial crisis period and addressing potential endogeneity concerns using a propensity score-matching procedure. Additionally, further analysis provides some evidence that equity issuance by firms with more-restrictive balance sheet covenants is negatively associated with future operating performance, suggesting that these firms may not efficiently use the raised capital.