RFS Advance Access published online on April 2, 2008
Review of Financial Studies, doi:10.1093/rfs/hhn017
Design and Renegotiation of Debt Covenants
University of California, Berkeley
Stanford University
Address correspondence to Nicolae Gârleanu, Haas School of Business, University of California, Berkeley, CA 94720; e-mail: garleanu{at}haas.berkeley.edu
JEL Classification: G32, G33, G34, D23, D86
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Abstract |
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We analyze the design and renegotiation of covenants in debt contracts as a specific example of the contractual assignment of property rights under asymmetric information. Specifically, we consider a setting where managers are better informed than lenders regarding potential transfers from debt to equity associated with future investments. This simple adverse-selection problem leads to the allocation of greater ex ante decision rights to the creditor (the uninformed party), i.e., tighter covenants, than would follow under symmetric information. This corresponds well to empirical evidence indicating that covenants are very tight upon inception and are frequently waived (and never tightened) upon renegotiation.
We are grateful to George Baker, Bernard Black, Patrick Bolton, Philip Bond, Peter DeMarzo, Itay Goldstein, Hayne Leland, Jonathan Levin, Michael Roberts, Neil Stoughton, Steve Tadelis, Ralph Winter, several anonymous referees, and seminar participants at Carnegie Mellon, Columbia University, DePaul University, Duke University, New York University, Stanford University, the University of British Columbia, University of California, San Diego, The University of Utah, University of Southern California, the American Finance Association Meetings, the NBER Conference on Organizations, the European Finance Association Meetings, and the Western Finance Association Meetings for helpful comments.