Capital Versus Performance Covenants in Debt Contracts

Abstract

Building on contract theory, we argue that financial covenants control the conflicts of interest between lenders and borrowers via two different mechanisms. Capital covenants control agency problems by aligning debt holder–shareholder interests. Performance covenants serve as trip wires that limit agency problems via the transfer of control to lenders in states where the value of their claim is at risk. Companies trade off these mechanisms. Capital covenants impose costly restrictions on the capital structure, while performance covenants require contractible accounting information to be available. Consistent with these arguments, we find that the use of performance covenants relative to capital covenants is positively associated with (1) the financial constraints of the borrower, (2) the extent to which accounting information portrays credit risk, (3) the likelihood of contract renegotiation, and (4) the presence of contractual restrictions on managerial actions. Our findings suggest that accounting‐based covenants can improve contracting efficiency in two different ways.

Structure and restrictiveness of financial covenants in bond contracts on Catalyst

“…A violation of incurrence covenants is easy to avoid, so they have a minor value for debt holders in comparison to maintenance covenants and as consequence incurrence financial covenants are not the focus of academic research (Tappeiner, 2010). In our detailed analysis we also focus only on maintenance covenants dividing them into two types: capital covenants and performance covenants, as proposed by Christensen and Nikolaev (2011). As indicated in the literature review (Section 2), financial covenants are the focus of the academic research which suggest that they are often used playing an important role in limiting conflicts between shareholders and debt holders.…”

“…The author concludes that the decline in use of balance sheet covenants is associated with changes in accounting standards which made the balance sheet less useful for contracting. Christensen and Nikolaev (2011) focus in their research on examining the role of accounting-based covenants in limiting agency costs and they classify covenants into two groups: capital covenants which are based on information about sources and uses of capital (balance sheet information only) and performance covenants which are formulated in terms of current-period profitability and efficiency indicators. The authors argue that the two groups of covenants reduce agency costs in two different ways.…”

Debt Renegotiation and Debt Overhang: Evidence from Lender Mergers

“…While previous studies show that firms more subject to debt overhang ex ante may design debt contracts that can be more easily renegotiated (Myers 1977, Aivazian and Callen 1980, Sufi 2007, and Christensen and Nikolaev 2012, they provide no direct evidence of the effect of renegotiation on debt overhang. The analysis of debt renegotiation in Roberts and Sufi (2009) and Roberts (2015) suggests that debt renegotiation may be used to resolve the debt overhang problem, but they also provide no direct evidence, especially no direct causal evidence, that debt renegotiation mitigates debt overhang.…”

The Debt-Contracting Value of Accounting Numbers, Renegotiation, and Investment Efficiency

“…formance pricing provisions, and more collateral requirements (Ball et al 2008;Bharath et al 2008;Graham et al 2008;Costello and Wittenberg-Moerman 2011;Christensen and Nikolaev 2011;Kim et al 2011). If these contracting terms are perfect substitutes for accounting-based contractual features, one should not expect a relation between the debt-contracting value of accounting numbers and any ex post renegotiation after controlling for these loan characteristics.…”