Agency Costs, Information, and the Structure of Corporate Debt Covenants

Abstract

We analyze the determinants of covenant structure in private debt contracts. While previous studies have demonstrated a relationship between firm characteristics and the overall strictness of loan contracts, few studies have examined why covenants are written on a range of accounting variables and what determines their selective use. Using a simple model of firm investment where firms face uncertain cash flows and investment opportunities, we characterize the conditions under which it is optimal for a debt contract to specify a restriction on investment or to specify a minimum cash flow realization. Consistent with this model, we find that the application of covenants based on these variables is not necessarily monotonic in firm risk. While the financially riskiest firms tend to employ capital expenditure covenants, cash flow and net worth covenants are most common among moderately risky firms with greater profitability and firms with stronger banking relationships. The results also highlight the importance of debt covenants in both mitigating agency frictions and maximizing the value of future private information.