Dynamic threshold values in earnings-based covenants
Journal
Journal of Accounting and Economics
Subject
Accounting
Publishing details
Authors / Editors
Li N; Vasvari F; Wittenberg-Moerman R
Biographies
Publication Year
2016
Abstract
We examine the role of dynamic covenant threshold values in syndicated loan agreements. We document that 45% of syndicated loans specify dynamic covenant thresholds in earnings-based covenants and that these changing thresholds typically become tighter over the life of a loan. We find that covenants with a tight trend provide an important signaling mechanism that meets the needs of borrowers that experience an inferior financial performance at loan initiation but expect future performance improvements. Specifically, we find that these covenants provide underperforming borrowers with a grace period by requiring less restrictive initial thresholds. At the same time, they allow these borrowers to credibly convey information to lenders about their future prospects via gradually more demanding subsequent thresholds. Our empirical evidence also suggests that while lenders entering into tight threshold trend covenant contracts receive weaker covenant protection over the grace period, they benefit from having stronger control rights in subsequent periods.
Keywords
Syndicated loans; Financial covenants; Covenant threshold trend; Signaling hypothesis; Incomplete debt contracting theory
Available on ECCH
No
