Signaling through Dynamic Thresholds in Financial Covenants

Date
2017-08-28
Authors
Fang, Shunlan
Chava, Sudheer
Prabhat, Saumya
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Abstract
Among private loan contracts with covenants originated during 1996-2012, 35% have financial covenant thresholds that automatically increase according to a predetermined schedule. Firms that accept these dynamic thresholds receive a lower interest spread and improve their creditworthiness relative to matched control firms. However, in the event of a covenant violation, these firms are less likely to receive a waiver, more likely to pay higher waiver fees, experience greater investment cuts, and are more likely to switch lead lenders than control firms. Overall, our findings suggest that signaling through dynamic thresholds in covenants is credible but costly to borrowers.
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Keywords
loan covenant design, consequences of signaling, creditor control, information asymmetry
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