Large–Sample Evidence on the Debt Covenant Hypothesis

We use Dealscan , a database of private corporate lending agreements, to provide large–sample tests of the debt covenant hypothesis. Dealscan offers several advantages over the data available in previous studies, principally larger and more representative samples and the availability of extensive actual covenant detail. These advantages allow us to construct powerful tests in which we find clear support for the debt covenant hypothesis. We also use these data to provide broad evidence on the economic role of debt covenants. We find that private lenders set debt covenants tightly and use them as "trip wires" for borrowers, that technical violations occur relatively often, and that violations are not necessarily associated with financial distress. Finally, since we measure covenant slack directly, we report evidence that the extensively–used leverage variable is a relatively noisy proxy for closeness to covenants.     

Bank lending to targets of active takeover attempts: The simultaneous choice of loan maturity,pricing, and security

I investigate bank loans to takeover targets considering the simultaneous decision of pricing, maturity, collateral, and covenants applying Generalized Method of Moments (GMM). Results are largely in line with the Agency Theory of Covenants (ATC) as pricing for new bank debt is lower given greater collateral and covenant protection, consistent with existing literature on public debt. However, poor performing targets demonstrate a positive relationship between pricing and covenants while bank loans to high performers are consistent with ATC predictions. Finally, loan terms tied to ex post observations of merger outcomes suggest banks possess some knowledge of merger outcomes in advance.     

The Determinants of Debt Maturity at Issuance: A System-Based Model

We examine the determinants of corporate debt maturity while taking into account the interdependent relation between maturity and leverage. We do this by estimating a simultaneous-equations model on debt maturity and leverage for a sample of bond-issuing firms. To compare with previous studies, we also estimate a single-equation model on debt maturity using OLS. We define debt maturity as either the maturity of bonds at issuance (incremental approach), or the percentage of a firm's total debt that matures in more than three years (balance-sheet approach). Corroborating the findings of many previous studies, our single-equation OLS results support the underinvestment hypothesis purporting that firms with greater growth opportunities have shorter-term debt. However, under the simultaneous-equations model, the negative relation between a firm's debt maturity and its growth opportunities ceases to hold. Instead, it is the leverage decision that is influenced by growth opportunities. This suggests that existing models may overestimate the effect of growth opportunities on debt maturity.     

Debt Maturity Structure and Firm Investment

This study shows that the maturity structure of a firm's debt has a significant impact on its investment decisions. We show, after controlling for the effect of the overall level of leverage, that a higher percentage of long-term debt in total debt significantly reduces investment for firms with high growth opportunities. In contrast, the correlation between debt maturity and investment is not significant for firms with low growth opportunities. The results are strong at the firm level and at the business segment level. These results hold even after controlling for the endogeneity problem inherent in the relationship between total leverage, the maturity composition of leverage, and investment.     

How Entrenchment, Incentives and Governance Influence REIT Capital Structure

Although recent literature has confirmed the importance of viewing a firm??s capital structure choices of leverage and debt maturity as jointly determined, to date there has been little analysis of the importance of traditional governance variables on a firm??s capital structure decisions using a simultaneous equations approach. We examine the influence of managerial incentives, traditional managerial monitoring mechanisms and managerial entrenchment on the capital structure of Real Estate Investment Trusts (REITs). Using panel data, we estimate a system of simultaneous equations for leverage and maturity and find that firms with entrenched CEOs use less leverage and shorter maturity debt. This is consistent with the expectation that managers acting in their own self interest will choose lower leverage to reduce liquidity risk and use short maturity debt to preserve their ability to enhance their compensation and reputations by empire building. We also find evidence that traditional alignment mechanisms such as equity and option ownership have an offsetting effect; and that firms where the founder serves as CEO choose higher leverage and longer maturity debt. The results also provide evidence that leverage and maturity are substitutes, firms with high profitability and growth opportunities use less leverage and firms with liquid assets use more leverage and longer maturity debt.     

Financial covenants in the markets for public and private debt

The public debt contracts surveyed in Whittred and Zimmer (1986) and Stokes and Tay (1988) were issued between 1962 and 1985, and there has been significant macroeconomic, institutional and regulatory change since that time. We analyse a sample of 36 recently issued Australian public debt contracts and document a considerable change in the ‘package’ of financial covenants used in public debt contracts. The covenant package is now less restrictive and the types of covenants used are more heterogenous. We also survey a sample of 41 recent Australian private debt contracts. These contracts contain a greater number, variety and, collectively, more restrictive set of financial covenants than those public debt contracts we survey, supporting theory which suggests that covenant restrictive and renegotiation–flexible contracts are more suited to borrowers contracting with financial intermediaries in private debt markets. We also note differences in accounting rules associated with financial covenants used in these private debt contracts.     

Utilisation and restrictiveness of covenants in Australian private debt contracts

This paper investigates the accounting based covenants typically contained in the private debt contracts of listed Australian firms. In particular, cross sectional determinants of variation in covenant utilisation and restrictiveness are investigated. The primary source of data presented in the paper is a questionnaire completed by senior corporate managers of banks lending to listed Australian firms. In addition, standard and actual bank loan agreements are analysed. The survey results indicate that there is considerable cross-sectional variation in the utilisation and restrictiveness of covenants included in Australian private debt contracts, with this variation being partially explained by firm size and industry membership. The covenants most likely to be included are leverage, interest coverage, current, and prior charges ratios.     

Bondholder governance,takeover likelihood,and division of gains

We investigate the effect of creditor rights on the probability of becoming a takeover target by constructing firm-level bond covenant indices. Our primary result is that the more restrictive covenants a firm has, the more likely it is to become the target of an acquisition. This finding is robust to the exclusion of merger-related event-risk covenants which have the opposite impact and appear to reduce takeover likelihood. Furthermore, this effect is not driven by financially distressed firms and rather contained in small, profitable, financially healthy firms with high growth opportunities and low cash holdings. We also find that a higher target covenant index leads to a significant decrease (increase) in target (acquirer) abnormal returns around acquisition announcements and tilts merger gains towards the acquirer, suggesting the presence of a ‘covenant discount’ for potential target firms. Overall, our results are consistent with covenants creating key frictions, and in turn, making firms viable targets for acquirers with possibly deep pockets.     

Impact of proximity to debt covenant violation on earnings management

We examine the impact of differential incentives arising from proximity to debt covenant violation on earnings management. We reason that firms with loans close to violation or in technical default of their debt covenants have a stronger incentive to engage in earnings management than firms that are far from violating their debt covenants. We find results consistent with this expectation. Firms close to violation or in technical default of their debt covenants engage in higher levels of accounting earnings management, real earnings management, and total earnings management than far-from-violation firms. In additional analysis, we find that firms with a stronger incentive to avoid covenant violation switched from using more accounting earnings management before the Sarbanes–Oxley Act to using more real earnings management and more total earnings management afterwards. We also document that the earnings management implications of debt covenant violation are observed primarily for firms with poor credit ratings and for firms that do not meet analyst forecasts.     

The joint determinants of cash holdings and debt maturity: the case for financial constraints

We examine the joint choices of cash holdings and debt maturity for a large sample of firms for the 1985–2013 period. We find that there is a positive relation between debt maturity and cash holdings. Our results hold after taking into account endogeneity among leverage, debt maturity, and cash holding. We posit that this positive relationship will be found among firms facing financial constraints and we find support for this hypothesis. Our results are robust after we control for agency problems, international taxation, bank loan liquidity covenants and default risk.     

Debt Maturity and the Effects of Growth Opportunities and Liquidity Risk on Leverage

I test the hypothesis that short debt maturity attenuates thenegative effect of growth opportunities on leverage. Using simultaneousequations with leverage and maturity endogenous, I find strongsupport for an economically significant attenuation effect.The negative effect of growth opportunities on leverage forfirms with all shorter-term debt is less than one-sixth as largeas the effect for firms with all longer-term debt. Short maturityalso increases liquidity risk, however, which negatively affectsleverage. The results suggest that firms trade off the costof underinvestment problems against the cost of liquidity riskwhen choosing short maturity.     

Managerial Stock Ownership and the Maturity Structure of Corporate Debt

This study documents that managerial stock ownership plays an important role in determining corporate debt maturity. Controlling for previously identified determinants of debt maturity and modeling leverage and debt maturity as jointly endogenous, we document a significant and robust inverse relation between managerial stock ownership and corporate debt maturity. We also show that managerial stock ownership influences the relation between credit quality and debt maturity and between growth opportunities and debt maturity.     

Uncertainty and debt covenants

I examine the use of financial covenants when contracting for debt under uncertainty. Uncertainty, in the context of this study, is a lack of information about future economic events and their consequences for the borrower’s creditworthiness. I examine the implications of ex ante uncertainty that is resolved by information received following loan initiation but prior to maturity. I argue that financial covenants, by transferring control rights ex post, provide a trigger for creditor-initiated renegotiation when the borrower is revealed to be of low credit quality. Using a large sample of private loans, I predict and find that financial covenant intensity is associated with greater uncertainty. I also revisit the agency-based explanation for covenant use and find that this uncertainty explanation is robust to various controls for agency conflicts.     

The Ex‐Ante Monitoring Role of Accounting Covenants in Public Debt

In contrast to what is known about accounting covenants in private debt, little empirical evidence on the role of accounting covenants in public debt exists. Diffuse ownership, arm's length monitoring, and collective action problems are unique to the public debt setting and raise the question of whether these covenants serve their intended role. As such, this study investigates whether including covenants reliant upon accounting inputs influences borrowers’ actions to prevent adverse credit events. Accounting covenants in the public debt setting provide firms with a disciplining mechanism to renegotiate ahead of costly technical default – a stark contrast to the ex‐post renegotiation ‘trip wire’ role covenants play in private debt. In particular, the results show that including accounting covenants in public debt is associated with an increased probability of ex‐ante renegotiation, that is, negotiation through consent solicitations ahead of covenant violation. This ex‐ante renegotiation, in turn, is associated with decreased adverse credit events. Cross‐sectional results support these findings as the ex‐ante renegotiation role of accounting covenants varies with bondholders’ and trustees’ monitoring ability.     

Firms' Off-Balance Sheet and Hybrid Debt Financing: Evidence from Their Book-Tax Reporting Differences

We match large U.S. corporations' tax returns during 1989–2001 to their financial statements to construct a firm‐level proxy of firms' use of off‐balance sheet and hybrid debt financing. We find that firms with less favorable prior‐period Standard & Poor's (S&P) bond ratings or higher leverage ratios in comparison to their industry report greater amounts of interest expense on their tax returns than to investors and creditors on their financial statements. These between‐firm results are consistent with credit‐constrained firms using more structured financing arrangements. Our within‐firm tests also suggest that firms use more structured financing arrangements when they enter into contractual loan agreements that provide incentives to manage debt ratings. Specifically, we find that after controlling for S&P bond rating and industry‐adjusted leverage, our sample firms report greater amounts of interest expenses for tax than for financial statement purposes when they enter into performance pricing contracts that use senior debt rating covenants to set interest rates. Furthermore, we find that the greatest book‐tax reporting changes occur when firms become closer to violating these debt rating covenants. These latter findings are consistent with firms' contractual debt covenants influencing their use of off‐balance sheet and hybrid debt financing.     

Debt covenant renegotiations and creditor control rights

Using a large sample of private debt renegotiations from 1996 to 2011, we report that, even in the absence of any covenant violation, debt covenants are frequently renegotiated. These renegotiations primarily relax existing restrictions and result in economically large changes in existing limits. Renegotiations of specific covenants are a response to both the distance the covenant variable is from its contractual limit and the firm?s specific operating conditions and prospects. Moreover, the borrower?s post-renegotiation investment and financial policies are strongly associated with the covenant changes resulting from the renegotiation. Overall, the findings imply that, even outside of default states, creditors have strong control rights over the borrower?s operating and financial policies, and they exercise these rights in a state contingent manner through covenant renegotiations.     

The role of audit verification in debt contracting: evidence from covenant violations

We investigate the role of audit verification in the resolution process following debt covenant violations. Using two sets of proxies for demand—audit fees and the independence and diligence of audit committees—we find evidence that covenant violations result in a demand for differentially higher levels of audit verification. Further analyses demonstrate the link between the increased demand for audit verification and the mechanisms designed to control agency costs in debt contracts. We document cross-sectional variations in the observed fee differential with respect to the level of reliance on financial covenants, the type of covenants violated, and waiver decisions. Moreover, we find that the observed audit fee increases are associated with more favorable movements in borrowing costs and the adoption of more conservative investment policies post violation. Our findings suggest that covenant violations increase the demand for audit services to help control contracting costs post violation.     

Debt covenants and asset versus equity acquisitions

We examine whether the presence of loan covenants leads firms to choose either an asset or equity acquisitions. Asset acquisitions involve the selective purchase of a target company's assets, and equity acquisitions involve acquisitions of common stocks. We document that firms with loan covenants are more likely to engage in asset acquisitions as opposed to equity acquisitions. Our results are robust to alternative measures of loan covenants and to endogeneity concerns. Furthermore, the association between loan covenants and asset acquisitions is stronger among firms with greater debt covenant intensity, more severe agency problems, and lower profitability. Acquirers facing more intense competition within their industries are also likely to choose asset acquisitions. Our findings suggest that acquirers' incentives to avoid wealth transfer at the expense of debtholders drive the relation between debt covenants and choice of acquisition structure.     

Bond covenants,bankruptcy risk,and the cost of debt

Are all covenants equally effective at reducing the bondholder-shareholder conflict? Examining the most frequently used bond covenants, we document that four out of 24 restrictions are associated with significantly higher bankruptcy risk. The use of these Default Indicating covenants can be partly explained by faulty contract design, greater recovery in bankruptcy, or within-creditor conflicts. Firms that use In-House Counsel to help structure their bond issue and those that use Big 4 Auditors are also less likely to include Default Indicating covenants in their bonds. Further tests show that the use of these Default Indicating covenants is associated with higher bond and CDS spreads. Overall, the results help explain the prior evidence on the relation between covenant use and the cost of debt.     

Interactions of corporate financing and investment decisions: The effects of agency conflicts

We examine interactions between flexible financing and investment decisions in a model with stockholder–bondholder conflicts over investment policy. We find that financial flexibility encourages the choice of short-term debt thereby dramatically reducing the agency costs of under- and overinvestment. However, the reduction in agency costs may not encourage the firm to increase leverage, since the firm's initial debt level choice depends on the type of growth options in its investment opportunity set. The model has a number of testable predictions for the joint choice of leverage and maturity, and how these choices interact with a firm's growth opportunities.