Capital versus Performance Covenants in Debt Contracts

TLDR: In this paper, the contracting role of financial covenants classified into two types, namely, capital covenants and performance covenants, is studied. And the authors find that performance co-venants are strong predictors of future contract renegotiations, while this is not the case for capital co-conditions.

Abstract: We study the contracting role of financial covenants classified into two types. We argue that capital covenants control agency problems by maintaining sufficient equity capital and hence aligning debtholder-shareholder incentives, whereas performance covenants serve as tripwires that facilitate early transfers of control and renegotiations when performance deteriorates. We find that capital and performance covenants are negatively correlated but are not used interchangeably. Performance covenants are strong predictors of future contract renegotiations, while this is not the case for capital covenants. Further, restrictions on certain managerial actions are less common in conjunction with capital covenants, in line with their incentives alignment effect. We also study how the contracting value of accounting information affects covenant package design. We predict and find that performance covenants are contracted on when accounting information is descriptive of credit quality, while the opposite holds for capital covenants. This relation implies that properties of accounting information have a sizable effect on the design of financial contracts.