Factors affecting the scope and initial tightness of covenant restrictions in private lending agreements*

Abstract

Abstract. This paper explores restrictions in private lending agreements to determtne how contractors" status affects (I) the number of limitations on managerial actions and (2) tighttiess (or slack) of contract restrictions at contract inception. The major result of the multivariate tests is that highly leveraged borrowers are forced to negotiate agreements with both more numerous and tighter restrictions. Debt contracts represent a series of rational trade-offs. Firms with higher debt face more restrictions, which are tighter and more likely to restnct managerial actions. Similarly, borrowers are more likely to agree to tighter extensive restrictions in exchange for more substantial loans. The evidence also indicates that larger firms that possess greater resources to avoid default are able to negotiate looser agreements that contain fewer restrictions. Secured loans do not impose a large number of accounting-based restrictions on managements" actions because secured lenders have less need to restrict managements" options. However, longterm agreements, including insurance loans, include more restrictions on dividends and payout options but use covenant ratios to allow managemeni the flexibility needed over the course of a long-term loan.Resume. Les auieurs etudient les clauses resirictives des contrats de pret prives afin de determiner commeni la situation des contractants infiue sur i) le nombre des limites imposees a la direction dans sa marge de manoeuvre et 2) la rigueur (ou la malleabilite) des restrictions contractuelles au debut du contrat. Une constatation principale resulte des tests a plusieurs variables aleatoires : les emprunteurs dont le tevier financier est important se voient contraints de negocier des contrats contenant a la fois des restrictions plus nombreuses et plus rigoureuses. Les contrats d'emprunt sont en quelque sorte une serie de compromis rationnels. Les entreprises dont la dette est plus elevee font face a (lavantage dc restrictions, qui sont plus limitatives ct plus susceplibles de reduirc la marge de manoeuvre de la direction. D'autre part. !es emprunieurs sont plus enclins a accepter que leur soient imposees des restrictions plus rigoureuses et plus nombreuses, en echange de prets plus substantiels. Les resultats de la recherche revelent egalement que les entreprises plus grandes disposant de ressources plus importantes qui diminuent le risque de non-rcmboursement soni en mesure de negocier des ententes plus souples qui contiennent moins de restrictions. Les preis garantis n"iinposent pas beaucoup dc restrictions comptables a la marge de manoeuvre de la direction, puisque les preteurs garantis eprouvent moins la necessite de restreindre les options de la direction. Toutefois. les contrats a long terme, parmi lesquels les prets de compagnies d'assurance, component davantage de restrictions relatives aux dividendcs et aux options de remboursement mais prevoietit dans leurs clauses restrictives des ratios moins severes, de faCcon a assurer a la direction la souplesse qui lui est ncce...

Fixed Asset Revaluation and Equity Depletion in the UK

“…Following prior research, we predict that the probability of revaluation is a positive function of gearing. Gearing serves both as a measure of the tightness and number of existing accounting-based covenant restrictions (Duke and Hunt, 1990;Press and Weintrop, 1990;and El-Gazzar and Pastena, 1991) and because of its informational role in signalling financial problems. 6 In the UK, where much of the debt of the corporate sector takes the form of renewable short-term bank finance, the implicit contracting and signalling aspects are likely to be of particular importance.…”

An analysis of factors influencing asset writedowns

“…An alternative argument is that highly levered firms are more likely to have the value of their assets under scrutiny by debtholders as part of the firm's corporate governance processes (El Gazzar and Pastena, 1991;Harris and Raviv, 1990;Ofek, 1993;and Phillips, 1995), and they could be required to writedown overvalued assets as a consequence of intervention by debtholders. Empirical evidence of an association between higher leverage and writedowns reported in prior United States writedowns studies supports this argument (Strong and Meyer, 1987;Elliot and Shaw, 1988;and Zucca and Campbell, 1992).…”

Conservative accounting as a signaling device in debt covenants

“…Wang (2013) supports the signaling theory of conservative accounting finding that high-risk firms tend to show higher degrees of conservatism. Other studies, as Leuz et al (1998), El-Gazzar andPastena (1991) and Begley and Chamberlain (2005) find no significant correlation between conservatism and the use of covenants in debt contracts. This brief review of the literature shows that the empirical findings are inconclusive, and the present paper adds to understanding why this is the case.…”