Dynamic threshold values in earnings-based covenants

Vasvari, F and Li, N and Moerman-Wittenberg, R (2016) Dynamic threshold values in earnings-based covenants. Journal of Accounting and Economics, 61 (2-3). pp. 605-629. ISSN 0165-4101

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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.

Item Type: Article
Additional Information: © 2016 Elsevier
Subject Areas: Accounting
DOI: 10.1016/j.jacceco.2015.07.004
Date Deposited: 02 Mar 2016 18:51
Last Modified: 09 Oct 2017 14:37
URI: http://lbsresearch.london.edu/id/eprint/112

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