Covenants in Private and Public Debt Contracts and Their Effects on Corporate Performance

To loan or not to loan, that is the question. Debt capital providers are haunted by the ghost of default and are now desperate for tools capable of providing early signs of credit problems. Covenants may help, as they give creditors the right to ask for early payment when a covenant is breached. Professor Florin Vasvari has started to collect relevant debt contracts issued by both American and European firms in order to see how covenants can really improve protection for lenders. His research aims to help debt market practitioners (both on the borrowing and lending side) better understand the consequences of covenant structures in debt contracts on the subsequent performance of the borrowing firms. It may thus provide relevant insights to financial regulators.
Preliminary results show that low expected bankruptcy costs are associated with stricter definitions of the event of default in lending contracts. This result highlights the tradeoffs faced by lenders. When the transaction costs generated by the liquidation of a borrower are lower, lenders are more inclined to add strict covenants in the lending contract.