Renegotiation and the Choice of Covenants in Debt Contracts

Abstract

I investigate whether and how expected future contract renegotiation considerations affect the type of covenants used in ex-ante debt contracts. I find that when future contract renegotiation costs are expected to be high, debt contracts are less likely to include covenants that restrict the borrower's financial flexibility in good states. This finding suggests that when renegotiation costs are high, borrowers and lenders avoid the use of covenants that are more likely to hold up the borrower and force it to bypass valueenhancing corporate policies (e.g., investments). Consistent with this interpretation, the negative relationship between renegotiation costs and the presence of flexibility-reducing covenants becomes stronger when the borrower has fewer outside options and financial flexibility becomes more valuable. Finally, I find that when future renegotiation costs are expected to be high, debt contracts have more covenants that are directly linked to the current performance of the borrower, which allows for a more efficient allocation of decision rights between the borrower and lenders. Overall, this study provides initial evidence about how renegotiation considerations affect the design of covenant packages in debt contracts.

Initial Conditions and the Private Debt Renegotiation Process

“…On the other hand, in a recent study Nikolaev (2016) shows that contracting frictions, agency, information problems, and ultimately demand for lender's monitoring drive the renegotiations. In related papers, Saavedra (2015) find that the expectations of future contract renegotiation affect the design of initial debt contracts while Paligorova and Santos (2016) show that the initial syndicate composition and structure has a significant impact on renegotiation likelihood. Therefore, the impact of the initial conditions on renegotiation calls for more empirical research.…”

“…Another strand of the literature studies the links between specific contractual features, such as covenants, and the renegotiation process(Asquith et al, 2005;Dou, 2016;Saavedra, 2015) and the consequences of renegotiations on firm performance(Denis and Wang, 2014;Miyakawa and Ohashi, 2016).…”

Consequences of Debt Forgiveness: Strategic Default Contagion and Lender Learning

“…Lenders frequently renegotiate loans (Dichev and Skinner [], Roberts and Sufi []) to reallocate state‐contingent control rights (Christensen, Nikolaev, and Wittenberg‐Moerman [], Nikolaev []). Although the costs of renegotiations for borrowers and lenders have received extensive attention (e.g., Beneish and Press [], Asquith, Beatty, and Weber [], Saavedra []), renegotiations can also influence the behavior of other borrowers if they learn about the renegotiated terms. To my knowledge, this study is the first to measure information spillovers from debt forgiveness.…”