Dynamic Threshold Values in Earnings-Based Covenants*

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1 Dynamic Threshold Values in Earnings-Based Covenants* Ningzhong Li University of Texas at Dallas 800 West Campbell Road, Richardson, TX, USA Florin P. Vasvari London Business School Regent s Park, London, NW1 4SA, United Kingdom fvasvari@london.edu Regina Wittenberg-Moerman The University of Chicago Booth School of Business 5807 South Woodlawn Avenue, Chicago, IL, USA regina.wittenberg-moerman@chicagobooth.edu First Draft: April 2012 This Draft: July 2013 *We appreciate the helpful comments of Phil Berger, Doug Diamond, Doug Skinner, Scott Richardson, Michael Roberts and Andrew Winton, participants at the University of Minnesota Empirical Conference and the 49 th Bank Structure Conference at Chicago Fed, and seminar participants at London Business School, Tilburg University, the University of Chicago and the University of Michigan. We thank Greg Nini, David Smith and Amir Sufi for covenant violations data and Yiwei Dou for covenant renegotiations data. We also thank Ying Huang, Yun Lou, Yu Xie and Sundipika Wahal for excellent research assistance. We gratefully acknowledge the financial support of the AXA Research Fund, the London Business School RAMD Fund and the University of Chicago Booth School Of Business. Regina Wittenberg-Moerman also gratefully acknowledges the financial support of the Neubauer Family Fellowship. This paper was previously circulated under the title The Information Content of Threshold Values in Earnings-Based Covenants.

2 Dynamic Threshold Values in Earnings-Based Covenants Abstract In this study, we examine the role of changing covenant threshold values in syndicated loan agreements. We find that 45% of syndicated loans specify changing covenant thresholds in earnings-based covenants and that these thresholds typically become tighter over the life of the loan. We hypothesize and find that a tight threshold trend reflects a contingent allocation of control rights between borrowers and lenders, in which lenders relax the lending criteria initially, providing borrowers with a temporary grace period and then obtain control if borrowers cannot meet the increasingly demanding performance thresholds over the loan s duration. We view our findings as corroborating the incomplete debt contracting theory of Aghion and Bolton (1992) and Dewatripont and Tirole (1994) and as shedding light on the role of earnings-based covenants in the ex-ante allocation of control rights at loan initiation. Keywords: syndicated loans, financial covenants, covenant threshold trend, creditor control rights, incomplete debt contracting theory JEL Classifications: G17, G21, G32, M41

3 1. Introduction The theory of financial contracting under asymmetric information provides a general framework for understanding why information-intensive borrowers rely on sophisticated bank lenders to issue debt securities. These lenders issue loan contracts with complex covenant structures that allow them to obtain control rights when borrowers engage in asset substitution and wealth expropriation or fail to meet predefined performance thresholds. 1 Prior empirical work has examined the determinants of specific covenants and the number of covenants included in loan agreements (e.g., Bradley and Roberts, 2004, Demerjian, 2011, and Christensen and Nikolaev, 2012) or has explored factors that explain the tightness of the financial covenants in the initial contract (e.g., Dichev and Skinner, 2002, Chava and Roberts, 2008, Drucker and Puri, 2009, Demiroglu and James, 2010, Murfin, 2011). Our study provides novel empirical evidence on another important characteristic of financial covenants threshold values that change over the life of the loan. We document the frequency and patterns of these dynamic thresholds and examine factors that explain their use in loan contracts. Despite the critical role of covenants in the state-contingent allocation of control rights between borrowers and lenders (Aghion and Bolton, 1992, Dewatripont and Tirole, 1994), the extant empirical literature provides limited evidence on financial covenant terms that affect when lenders gain control. Because the changing thresholds provide a forward looking view of the contracting parties on the performance standards that need to be met by the borrower over the duration of the loan agreement, our investigation of these thresholds presents a unique opportunity to examine how the allocation of control rights is designed at loan origination. Financial covenants in loan contracts almost always include a measure of periodic operating cash flows such as EBITDA or an adjusted EBITDA number. Using a large sample of 1 See Jensen and Meckling (1976), Myers (1977), Smith and Warner (1979), Aghion and Bolton (1992), Berlin and Mester (1992), Dewatripont and Tirole (1994) and Rajan and Winton (1995). 1

4 syndicated loan contracts, we code the thresholds present in five earnings based financial covenants, the Interest Coverage (IC) covenant, the Fixed Charged Coverage (FCC) covenant, the Debt Service Coverage (DSC) covenant, the Debt to Cash Flows (DCF) covenant and the EBITDA covenant, which are the most common financial covenants required by bank syndicates. We find that almost 45% of the syndicated loan contracts specify, for at least one earnings-based covenant, a grid that designates how the covenants thresholds change over the life of the loan contract, including the exact date when the new threshold applies, as well as its value. Covenants may have a tight trend, which sets stricter threshold values over a contract s duration relative to the threshold at contract initiation. For example, an interest coverage ratio may be set at 1.5 during the first quarter after a loan s initiation, 1.75 during the following two quarters and 2.5 thereafter. We find that, across the five earnings-based covenants mentioned above, a tight threshold trend is present in 20 to 40 percent of the contracts. Earnings-based covenants can also have a looser trend, which relaxes the initial threshold value, or a fluctuating trend, which includes both increasing and decreasing thresholds, but these trends are present in a very small proportion of earnings-based covenants. We hypothesize that covenant thresholds that become gradually tighter over the duration of the loan contract reflect lenders willingness to lower their credit standards at issuance and provide borrowers with a temporary grace period following the loan s origination. Lenders are likely to agree to lower initial covenant thresholds for borrowers who do not have sufficiently strong financial performance at loan origination but who have the potential to enhance their performance following the debt financing. By subsequently increasing covenant thresholds, lenders obtain strong control rights if the borrower does not demonstrate a sufficient improvement in performance. This contingent allocation of control rights, shaped by increasingly tight covenant 2

5 thresholds, illustrates the incomplete debt contracting theory, pioneered by Aghion and Bolton (1992), Berlin and Mester (1992), Aghion et al. (1994) and Dewatripont and Tirole (1994). In the Aghion and Bolton (1992) framework, because borrowers actions cannot be completely contracted on, lending contracts include covenants that efficiently allocate decision rights in a stage-contingent manner, with control allocated to creditors in states of the world in which a signal indicates that borrowers are biased towards inefficient behaviour. This contractible signal can be provided by an earnings-based covenant. Earnings-based thresholds with a tight trend are likely to reflect a sophisticated allocation of control rights, in which it is more efficient for lenders to initially relax the lending criteria and then obtain control if the borrowers cannot meet the increasingly demanding performance thresholds over the loan s duration. However, an alternative explanation for the presence of earnings based covenants with a tight threshold trend, rooted in the theory of the informativeness of debt contractual terms (e.g., Chan and Kanatas, 1985, Besanko and Thakor, 1987, Garleanu and Zwiebel, 2009), is that borrowers commit to covenants with threshold values that become tighter over the life of the loan to credibly signal to lenders their quality, including favourable information about future financial performance (Signalling Hypothesis). Garleanu and Zwiebel (2009), who model the design of debt covenants under asymmetric information, demonstrate that managers with fewer wealth transfer activities at their disposal and who are better informed than lenders signal their good type by committing to tight covenants. Providing strong empirical support for the informativeness of debt contractual terms, Demiroglu and James (2010) find that borrowers who commit to tight covenant slack at loan initiation experience future improvements in their performance, while Manso, Strulovici and Tchistyi (2010) document that borrowers accepting performance pricing provisions are more likely to improve their credit ratings than are borrowers choosing fixed-interest loans. 3

6 We first document that, controlling for fundamental firm and loan characteristics, the initial threshold value in covenants with a tight trend feature is significantly less restrictive than it is in covenants with a constant trend, suggesting that a tight trend is associated with lower credit standards at the commencement of the debt contract. 2 However, the final threshold surpasses the constant covenant threshold level. 3 Taken together, these results provide preliminary evidence supporting the Grace Period Hypothesis. More favourable initial thresholds should help borrowers to retain control rights over the grace period, but lenders will be in control if the borrowers cannot meet the increasing thresholds. Higher final threshold values relative to the constant threshold also suggest that lenders agree to lower initial covenant thresholds, conditional on stronger control rights after the grace period terminates. Second, we investigate the characteristics of a borrower that explain the use of a tight threshold trend in the specification of at least one earnings-based covenant in the loan contract. Consistent with the Grace Period Hypothesis, we find that relative to a benchmark group of borrowers, borrowers with a tight trend covenants have poorer financial performance and lower creditworthiness at loan initiation. These borrowers have lower interest coverage and operating cash flow ratios, a less favourable Ohlson (1990) bankruptcy score, higher leverage and lower tangibility and are more likely to report a loss or experience a financial covenant violation prior to the loan s issuance. In addition, we measure the steepness of the tight trend (the "speed" with which the covenant thresholds become more restrictive over the life of the loan contract) and find that it is higher for borrowers with lower profitability and operating cash flows and for borrowers experiencing losses. This evidence suggests that a relatively more inferior financial performance among borrowers that receive tight trend covenants is associated with a quick 2 We perform this analysis only for the IC, FCC and DCF covenants. We exclude from these analyses both DSC covenants, due to their low frequency, and EBITDA covenants, because EBITDA thresholds vary significantly with the size of the firm and may be negative at loan initiation, making cross sectional comparisons difficult. 3 The grace period typically spans one year till the first increase in the covenant threshold (20% of a loan s maturity) and two and a half years till the final increase in the threshold value (50% of a loan s maturity). 4

7 acceleration of the threshold values. Thus, while these borrowers are provided with a grace period, lenders require a more rapid improvement in their financial performance. In an additional analysis, we also find that borrowers with stronger bargaining power are more likely to obtain covenants that provide them with a grace period. We measure bargaining power based on the number of lead arrangers that syndicated the borrowers previous loans, as borrowers with a higher number of previous relationships can credibly threaten to obtain a loan from other lenders (Rajan 1992). We also consider borrowers bargaining power to be reduced during periods of tight credit supply, such as the recent financial crisis. While we expect borrowers with strong bargaining power to more likely receive lenders concession to provide them with a grace period, we do not see a clear relation between bargaining power and a borrower s signalling incentives. An association between bargaining power and the tight trend feature also suggests that a borrower s bargaining power at loan initiation influences the ex-ante allocation of control rights through its effect on the structure of earnings based covenants. Third, supporting the need for a grace period at the beginning of the lending contract, we show that relative to a benchmark group of borrowers, borrowers with tight trend covenants experience deterioration in their performance in the first year after the loan issuance across three performance measures profitability, interest coverage and debt to EBITDA ratios. However, this deterioration is temporary, as the performance improves in the second and third years following the loan issuance. This evidence is consistent with our prediction that lenders are willing to offer a grace period to borrowers who do not have a sufficiently strong initial performance, but who have the potential to enhance their performance over time. Fourth, we examine whether a tight trend feature provides lenders with a mechanism for recontracting, consistent with lenders stronger control rights when covenant thresholds increase. We show that the presence of a tight trend is associated with the higher probability of a covenant 5

8 renegotiation within three years following the loan issuance. These results suggest that lenders trade off relaxing initial lending standards with stronger subsequent control rights. While covenant renegotiation tests support our Grace Period Hypothesis, we caveat these analyses as the choice of covenant trend is endogenous to the borrower s credit risk, suggesting that omitted credit risk factors may explain our findings. When considered in their entirety, our results, including significantly lower initial threshold values for covenants with a tight trend, the relatively weak performance of borrowers that obtain a covenant with a tight trend, the deterioration in their performance in the first year following the loan issuance and the higher probability of covenant violations and renegotiations, do not support the Signalling Hypothesis. To further investigate the credibility of this alternative explanation, we examine the effect of relationship lending on the presence of a tight trend. Based on its previous transactions with the borrower, a relationship lender typically has extensive knowledge of a borrower s operations and well developed channels of communication with its managers. As a result, one would expect less "signalling" via a tight trend feature when a relationship lender is underwriting the loan, relative to non-relationship loans. The empirical evidence reveals that there is no difference in the propensity to use tight trend covenants across relationship and nonrelationship loans, further suggesting that signalling is an unlikely explanation for the presence of this covenant feature. In a final set of analyses, we explore the association between covenants with a tight trend and other loan terms which are also expected to affect the ex-ante allocation of control rights. We view these tests as mainly descriptive, because we cannot address the endogeneity related to the joint determination of different contractual terms. We first examine net-worth covenants with income-based escalators, which specify what percentage of positive net income will be excluded from net-worth estimation to examine whether a borrower meets the net worth covenant 6

9 threshold (Beatty et al., 2008). We find that a tight trend feature and an income-based escalator complement each other when both earnings-based and net worth covenants are included in the loan contract. Next, we focus on the performance pricing provisions. 4 Roberts and Sufi (2009) suggest that interest increasing provisions may lead to contract renegotiation because the increase in the interest spread, pre-specified by the pricing grid, is typically very sharp, incentivizing the borrower to renegotiate. We find a negative association between a tight threshold trend and the interest increasing provision, suggesting that lenders do not employ both of these terms simultaneously in the contract. In contrast, we find a positive relation between a tight trend and an interest decreasing provision, which indicates complementarily between these terms. To shed further light on this association, we examine contracts where both the provision and the trend are based on the DCF ratio. We find that the interest decreasing grid overlaps with the tight trend range in the majority of the contracts, suggesting that when a borrower meets increasingly demanding thresholds, he often also benefits from a decrease in the interest spread. 5 The remainder of the paper is organized as follows. Section 2 presents the prior research that which motivates our analyses, and highlights our contribution to it. Section 3 describes the sample and data. Section 4 reports our main results and section 5 concludes. 2. Related Literature and Contribution Our study builds on and contributes to a large literature on debt contracting with covenants. Jensen and Meckling (1976), Myers (1977) and Smith and Warner (1979) show that covenants mitigate agency problems and conflicts of interest between debt and equity holders. Prior research shows that both the number of covenants and the tight covenant slack at debt contract 4 An interest increasing (decreasing) performance pricing provision increases (decreases) the interest rate over the life of the loan if the creditworthiness of the borrower declines (improves). These provisions are based on prespecified thresholds, which are typically credit ratings or financial ratios. For more details, see Asquith et al. (2005). 5 The debt to cash flow threshold in the most frequently used threshold in performance pricing provisions; this holds both for our sample and generally for US syndicated loans. 7

10 initiation increase lenders protection (e.g., Dichev and Skinner, 2002, Bradley and Roberts, 2004, Billett et al., 2007, Drucker and Puri, 2009, Murfin, 2011, Christensen and Nikolaev, 2012). Relative to these papers, our contribution lies in the analysis of a previously unexplored but widely used feature of the covenant structure a tight trend in covenant threshold values. By highlighting the importance of dynamic threshold in earnings-based covenants, our study also extends Beatty et al. (2008), who examine income escalators in net-worth-based covenants. Another contribution of our paper is to corroborate incomplete contracting theory (Aghion and Bolton, 1992, Berlin and Mester, 1992, Aghion et al., 1994, Dewatripont and Tirole, 1994), which, to date, has been subject to relatively little empirical evidence. We demonstrate that a tight threshold trend reflects a contingent allocation of control rights between borrowers and lenders, in which lenders initially relax the lending criteria, providing borrowers with a temporary grace period, and then obtain control if borrowers cannot meet the increasingly demanding performance thresholds. Our findings also emphasize the central role of earningsbased covenants in the design of the ex-ante allocation of control rights at loan origination. As such, our paper is related to the growing body of literature that studies how contingencies in debt agreements affect the contractual allocation of control power. While Asquith et al. (2005) and Nikolaev (2012) suggest that performance pricing provisions reduce the scope of renegotiations, Roberts and Sufi (2009) and Roberts (2013) find that performance pricing provisions do not prevent renegotiations but may prolong the duration between renegotiation rounds. Our findings also underscore the importance of the interaction between different debt contractual terms in shaping creditors control rights, as a tight threshold trend in earning-based covenants is associated with the structure of performance pricing provisions and net-worth-based covenants. 8

11 Finally, our paper is also relevant to research on the strictness of financial covenants (e.g., Dichev and Skinner, 2002, Beatty et al., 2008, Drucker and Puri, 2009, Murfin, 2011). Financial covenants serve as trip-wires as they inform lenders in a timely manner if a borrower s financial performance deteriorates, transferring the control rights to lenders before the borrower defaults on its obligations. With the notable expectation of Beatty et al. (2008), a multitude of empirical studies estimate covenant restrictiveness based only on the initial covenant threshold, typically provided by the DealScan database. Our study documents the dynamic nature of covenant thresholds in earnings-based covenants, which are the most frequently used covenants in syndicated loan contracts. Thus, our findings confirm that covenant strictness depends to a large degree on the trend in covenant threshold values and by ignoring subsequent threshold changes researchers are likely to introduce a significant measurement error in the strictness estimation. Due to the substantial consequences of lender intervention following covenant violation, such as an increase in the cost of debt and declines in borrowings and investments (Chava and Roberts, 2008, Roberts and Sufi, 2009, Nini et al., 2009, 2012, Freudenberg et al., 2012), the accurate estimation of the restrictiveness of financial covenants is particularly important. 3. Sample, Covenant Trend Characteristics and Descriptive Statistics 3.1. Data Sources and Sample Selection We obtain a comprehensive sample of syndicated loan contracts with financial covenants by searching all the 10-K, 10-Q and 8-K documents filed with the Securities and Exchange Commission (SEC) on the EDGAR online system over the period from 1996 to 2009 (electronic filings are not consistently available in EDGAR prior to 1996). We use a text-search program to scan these filings for syndicated loan contracts using combinations of the following keywords: 9

12 "credit agreement", "loan agreement", "credit facility" and/or "event(s) of default" (all loan contracts define events that trigger default in a dedicated "Events of Default" section). After identifying filings that contain syndicated loan contracts, we isolate the loan contract in the filing and match it manually to the syndicated loans available in DealScan, a database provided by the Thomson Reuters Loan Pricing Corporation (we previously linked DealScan to Compustat using the borrower s name, industry and location). For the period from 1996 to 2009, we obtain 15,519 loan packages outstanding to public non-financial U.S. firms with Compustat data available. The manual match of the DealScan loan data with the SEC filings results in a sample of 9,999 loan packages from 4,033 firms. To ensure the accuracy of this matching process, we make sure that the name of the borrower, the size of the loan package, the package date and the names of the lead arranger bank(s) stated in the loan contract in the SEC filing are exactly the same as in DealScan. We identify five earnings-based covenants in the sample loan contracts: interest coverage, fixed charge coverage, debt service coverage, debt to cash flows and minimum EBITDA. The interest coverage covenant (IC covenant thereafter) is typically defined as the ratio of an earnings number (e.g., EBITDA, EBIT, operating income, etc.,) to interest expense. The fixed charge coverage covenant (FCC covenant thereafter) is computed as the ratio of earnings to fixed charges, which may include interest expenses, principal payments, lease payments, etc. The debt service coverage covenant (DSC covenant thereafter) is measured as the ratio of earnings to debt service (interest and principal payments). The debt to cash flows covenant (DCF covenant thereafter) is generally the ratio of a debt measure (e.g., funded debt, senior debt, etc.) to an earnings measure (e.g., EBITDA or EBIT). Finally, the Min. EBITDA covenant is a covenant that requires a firm to maintain a minimum profitability level (EBITDA, EBIT, operating income, etc.). For each of these covenants, we code all threshold values and the corresponding timing of 10

13 changes in each threshold over the duration of the loan package. Conditional on the availability of at least one earnings-based covenant in the loan package contract, our final sample contains 6,826 packages from 3,182 firms. Table 1, Panel A summarizes this sample selection process. 6 As reported in Panel B of Table 1, the sample loan packages are fairly evenly distributed across years. In terms of industry distribution, the highest concentrations of packages are in the Wholesale, Retail and Some Services (16.03%), Manufacturing (15.32%) and Business Equipment (12.80%) industries (Panel C of Table 1) Characteristics of a Tight Threshold Trend and Descriptive Statistics To provide an example of different types of threshold grids used in syndicated loan contracts, in Appendix A we present extracts from a loan agreement between Citadel Broadcasting and its syndicate lenders signed on February 10, In this contract, the IC covenant becomes more binding over time. The covenant threshold that needs to be met (on a prior four quarter rolling basis) at the end of the first four quarters of the loan contract is 1.5. Starting from the fifth quarter, the threshold increases to 1.75 for three quarters. Subsequently, it increases to 2.00, then 2.25 and finally to 2.50 beyond the 11th quarter. The threshold values for the FCC covenant remain constant over the contract s duration at 1.25, while a third earningsbased covenant, the DCF covenant (or the leverage ratio), also has a threshold trend that becomes more binding over time. Panel A of Table 2 reports the frequency of the covenants in our sample, as well as the distribution of different threshold trend types across the five earnings-based covenants. The IC and DCF covenants are the most commonly used: the IC covenant is present in 3,079 loan packages (45% of the sample), while the DCF covenant is present in 4,458 packages (65% of the sample). The DSC covenant is the least used (only 6% of the loan packages have this feature). In 6 Our regression analyses have smaller samples due to additional restrictions on the data available to calculate the variables employed in the multivariate tests. 11

14 terms of threshold trends, the threshold becomes tighter in 30%, 27%, 16%, 41% and 42% of the packages for the IC, FCC, DSC, DCF and Min EBITDA covenants, respectively. The frequency of looser threshold trends is generally below 3%. Similarly, covenants with fluctuating trends are uncommon. The Min. EBITDA covenant is a notable exception; we find that about 18% of these covenants have a fluctuating trend. 7 The remaining contracts (55%) require a constant threshold value over the life of the syndicated loan contract. For covenants with a tight trend, we also measure the steepness of the trend, computed as an average of the slopes of each threshold change per quarter, weighted by the time periods corresponding to each threshold (Appendix A illustrates how this measure is estimated). The mean slope values for the IC, FCC and DSC covenants indicate that the strictness of these covenants increases on average by 4.7%, 5.0% and 7.3% per quarter, respectively (Panel B of Table 2). Because increasing threshold values for the DCF covenant indicate a looser covenant over time, we multiply its slope by -1; the strictness of this covenant increases on average by 3.7% per quarter. The mean slope for the Min EBITDA covenant is substantially larger at 34.1% per quarter; this is often due to this covenant s very low threshold values at loan origination or to a threshold grid that changes from negative to positive values. As a result, we exclude this covenant from the covenant steepness analysis. In Panel C of Table 2, we compare the initial and final threshold values across the tight trend and constant threshold partitions for IC, FCC and DCF covenants. We exclude from these analyses DSC covenants, due to their low frequency, and EBITDA covenants, because EBITDA 7 The fluctuating trend in the minimum EBITDA covenant is primarily due to its measurement interval. Earningsbased covenants are typically measured with rolling four quarters, but the minimum EBITDA covenant often has a quarterly or cumulative basis. We randomly check 50 contracts with minimum EBITDA covenants with a fluctuating trend and find that in 25 of them (50%), EBITDA is measured at on a quarterly basis; in 15 contracts (30%) it is measured cumulatively (first quarter, first two quarters, first three quarters, and so on). Due to business seasonality, measuring EBITDA at the quarterly level or cumulatively could lead to a fluctuating trend. In a contract, seasonality is removed when EBITDA is measured by rolling four quarters (as in the remaining earningsbased covenants). 12

15 thresholds vary significantly with the size of the firm and may be negative at loan initiation, making cross sectional comparisons difficult. We find strong statistical differences for the initial thresholds of all three covenants, suggesting that the initial thresholds in the tight trend group are significantly less restrictive than the thresholds in the constant group (the IC and FCC thresholds are lower and the DCF is higher). With respect to differences in the final thresholds, we find that for the IC and DCF covenants the final tresholds significantly surpass the constant threshold, which indicates that lenders trade off the grace period with subsequently more demanding thresholds. Figure 1 provides a graphical representation of the above analysis for the full sample and for partitions based on credit riskiness (based on the median O-score cut-off). These comparative statistics of the initial and final threshold values relative to the constant threshold hold for both partitions. Overall, this evidence provides initial support for the Grace Period Hypothesis. Panel D of Table 2 reveals that except for the EBITDA covenant, on average the grace period last for one year before the first increase in the covenant threshold, representing 20 to 30 percent of a loan s maturity. For EBITDA covenants, this period is only six months. The grace period until the final threshold value ranges from 1.7 years for DSC covenants to 2.5 years for IC and DCF covenants. For most covenants, this period spans half of a loan s maturity. In Figure 2, we present the plot of the proportion of loans with at least one earnings-based covenant with a tight trend for the full sample and for O-score partitions. The proportion of these loans ranges from 47% in 1998 to 23.3% in Less creditworthy borrowers are more likely to receive covenants with a tight trend; this relation holds for each year of our sample period. For firms with an above median O-Score, the proportion of loans with at least one earnings-based covenant with a tight trend decreases significantly over the crisis period and reaches 26.5% in In this year, the gap between the proportion of loans with a tight trend for more and less 13

16 creditworthy borrowers decreases to only 6%. This evidence suggests that when there is a tight credit supply, lenders are less willing to provide less creditworthy borrowers with a grace period. The usage of the tight trend feature increases in 2009, almost reaching the pre-crisis level Descriptive Statistics We construct two measures that capture the extent to which earnings based financial covenants become increasingly demanding over time. Tight Dummy is an indicator variable that takes the value of 1 if the loan package has at least one earnings-based covenant that becomes tighter over time, zero otherwise (see Appendix A for detailed variable definitions). 8 Our second measure, Slope, is computed only for loan packages that have at least one covenant with a tight trend; it captures the steepness of the trend at the package level. We measure the threshold slope by averaging the trend steepness of all earnings-based financial covenants in the package. Table 3, Panel A presents the descriptive for the variables we use in our tests. The mean values of Tight Dummy and Slope are 39% and 8.6%, respectively. There is a substantial variation in these variables, as we report in the standard deviation column. We also present other loan-specific characteristics. Loan packages have an average size of $332.57M. Given that a loan package typically has a number of tranches (loans) with different maturities, we compute a weighted maturity across all loans in the package using the tranche sizes as weights and obtain an average maturity of 3.8 years. The average number of financial covenants for the sample loan packages is % of the sample loans are issued for the purposes of acquisition and 29% are institutional term loans (versus revolving lines of credit and banking term loans). Almost half of the sample loans are issues by relationship lenders and majority of the borrowers have not syndicated loans with lead arrangers other than from the bank leading the current syndicate. 8 We also compute an alternative measure of the ratio of the number of earnings-based covenants with a tight threshold trend to the total number of earnings-based covenants in the loan package. This measure is highly correlated with Tight Dummy, so we unsurprisingly obtain very similar results (unreported). 14

17 We measured firm-specific characteristics in the quarter prior to the loan package issuance and obtain them from Compustat (all variables are described in Appendix B). The average ratio of earnings before extraordinary items to total assets (ROA) is 1.9% and about 25% of the sample firms report negative earnings before extraordinary items (Loss). The interest coverage ratio (Interest coverage) averages 13.5 and the ratio of operating cash flows to total assets (Cash flows) averages 10%. Sample firms have an average Ohlson s (1980) bankruptcy score (O-score) of (a less negative score indicates higher credit risk) and an average Leverage, measured as the ratio of long-term debt to total equity, of For the sample firms with an available credit rating, the mean (and median) S&P senior debt rating is BB. 9 15% of the sample loans experience covenant violations in the year prior to the loan issuance. The sample firms are relatively large, with a mean value of total assets of $2,121M. In Panel B, we also perform a comparative analysis between borrower characteristics for the tight versus constant sub-samples. Consistent with our predictions, borrowers that obtain loans with a tight threshold trend have a significantly inferior financial performance and lower creditworthiness prior to the loan issuance. 4. Results on the two hypotheses 4.1. Initial and final threshold values We start by testing the difference in the initial and final threshold values of covenants with a tight trend and the corresponding threshold values used in the constant threshold covenants. Consistent with the Grace Period Hypothesis, we expect that to facilitate the debt issuance for borrowers with relatively weak financial performance at loan initiation, lenders set looser initial covenant thresholds in loan packages with a tight trend, relative to the initial thresholds in 9 Firms senior debt ratings are obtained from the Standard and Poor's (S&P) historical database. If the S&P historical database does not cover a particular firm, we retrieve the Moody s, Fitch or Duff and Phelps senior debt rating from the Mergent Fixed Income Securities Database (FISD). For borrowers with missing ratings on S&P and FISD, we collect ratings from the Internet-based version of DealScan. 15

18 constant threshold covenants. Threshold values are expected to increase over the loan life, consistent with lenders request for strong control rights if these borrowers do not demonstrate a sufficient improvement in performance. On the other hand, the Signalling Hypothesis conjectures that earnings-based covenants with a tight threshold trend should be present in the contracts of borrowers that signal their quality, including a strong future financial performance. In this case we expect both the initial and final covenant thresholds to be higher for covenants with a tight trend relative to the benchmark constant threshold group. While the univariate analyses presented in Table 2, Panel C and Figure 1 provide some preliminary support for the grace period proposition, they do not take into account important borrower characteristics that are likely to affect the differences in the covenant thresholds across the two covenant groups. In Table 4, we present the results of multivariate analyses. We run the following specifications for IC, FCC and DCF covenants:. (1) Initial (Final) Threshold Value is the initial (final) threshold in the covenant specification (the initial and final values are the same for the constant threshold covenants). Trend Covenant is an indicator variable equal to 1 if the covenant has a tight trend, 0 otherwise. We use several firmspecific variables to reflect a borrower s financial performance and creditworthiness at loan initiation, including the return on assets, an indicator variable that reflects whether the firm s income before extraordinary items is negative, interest coverage, operational cash flows, O-score and leverage. We also control for a number of loan-specific characteristics likely to be associated with threshold values. We perform these and all other analyses both with and without loan controls due to the potential joint determination of loan terms (and the infeasibility of 16

19 concurrently endogenizing these terms). All the analyses also include industry and year fixed effects and we cluster the standard errors at the firm level. Panel A of Table 4 presents the results for regressions where the dependent variable is the initial threshold value. We find a negative association between the tight covenant dummy and the initial threshold in the IC and FCC covenants, suggesting that the initial credit standards for borrowers that receive covenants with a tight trend are significantly lower. Similarly, we find a positive association between the tight covenant dummy and the initial threshold of the DCF covenant. Thus, borrowers that receive DCF covenants with a tight trend can be more leveraged or have lower profitability (or both) relative to borrowers that receive DCF covenants with a constant threshold. These results are also economically significant. The initial thresholds for IC, and FCC covenants are lower by 0.4 and 0.15, respectively, and higher by 0.65 for the DCF covenant. These differences represent 14%, 9.6% and 18% of the mean threshold values of the respective covenants for the constant threshold group. We also find that borrowers with weaker financial performance at loan initiation receive lower covenant thresholds, as reflected by the coefficient on the majority of control variables. The lower initial thresholds for borrowers with tight trend covenants as well as the negative association between a borrower s performance and initial threshold values provide strong support for the Grace Period Hypothesis. In Panel B we replicate the analysis with the final threshold value as the dependent variable. We find mirror image results. Across all three covenants, the final threshold values are significantly more demanding for borrowers that receive loans with a tight threshold trend, relative to borrowers that receive loans with a constant trend. The final thresholds for IC and FCC covenants are higher by 0.33 and 0.15, respectively, and lower by 0.25 for the DCF covenant. These differences represent 11.5%, 9.6% and 6.9% of the mean threshold values of the respective covenants for the constant threshold group. Higher final threshold values relative to 17

20 the constant threshold suggest that lenders agree to lower initial covenant thresholds, conditional on stronger control rights after the grace period terminates. 4.2 Determinants of the Threshold Trend in Financial Covenants We next investigate the determinants of the presence of a tight threshold trend in earnings-based covenants. We estimate the following model:. (2) Tight Dummy is an indicator variable equal to 1 if at least one earnings-based covenant in a loan contracts has a tight trend, 0 otherwise. We include in the analyses a variety of firm and loan characteristics. The results reported in column 1 of Table 5 reveal that consistent with the Grace Period Hypothesis, relative to the benchmark group of borrowers, borrowers with a tight trend covenant have poorer financial performance and lower creditworthiness at loan initiation. These borrowers are more likely to experience losses, have a lower interest coverage ratio, a less favourable O- Score and be more leveraged. These results are also economically significant. For example, reporting losses in a year prior to a loan s issuance increases the probability of a tight trend feature by 5.9% and one standard deviation increase in O-score increases is by 5.5%. In column 2, as an additional proxy for a borrower s poor financial performance, we include an indicator variable reflecting whether a borrower violated a financial covenant in the year prior to the loan s issuance (Roberts and Sufi, 2009, Nini et al., 2009). This analysis is restricted to firms with available covenant violation data. We find that borrowers with previous covenant violations are more likely to receive tight trend covenants, providing them with a grace period. These results hold when we add loan characteristics in columns 3 and 4. We also show that loans with acquisition purposes (acquisition line and takeover) are more likely to be 18

21 characterized by a tight trend. The target company typically experiences a low performance prior to the acquisition as well as an additional temporary decrease in performance associated with the subsequent restructuring (in the majority of acquisitions, the target company subsumes the debt associated with the transaction), suggesting the need for a grace period. We also control for whether a loan is a term loan B or below. These loans are typically issued to institutional investors and have a back-end-loaded repayment structure. In contracts, banking term loans and revolvers have a front-end-loaded repayment structure. Thus, the existence of a tight trend for these loans may be driven by the mechanical need to update covenant thresholds: when a portion of a loan gets repaid, a firm s leverage decreases, potentially leading to a loose covenant threshold. We find that tight trend covenants are actually more likely in term loans B or below, inconsistent with a mechanical need to update thresholds. 10 We also find that the presence of a tight trend is increasing with loan size, maturity and the number of financial covenants. In columns 5 and 6 we perform additional tests to further shed light on the presence of a tight threshold trend. First, we incorporate proxies for a borrower s bargaining power. We expect borrowers with strong bargaining power to more likely receive a concession from lenders to provide them with a grace period, while we do not see a clear relation between bargaining power and a borrower s signalling incentives. Because borrowers with a higher number of previous relationships can credibly threaten to obtain a loan from other lenders if they are not satisfied with the current loan s terms (Rajan 1992), we expect bargaining power to increase with the number of lead arrangers that syndicated a borrower s previous loans. Because the majority of the sample borrowers have not syndicated loans from arrangers other than the bank leading the current syndicate (see Table 2, Panel A), we include in the analysis a dummy variable equal to one if a borrower has syndicated loans with at least one lead arranger other than the arranger in 10 We do not control for a loan s precise repayment schedule in our analyses as it is available for only 21% of our sample contracts. 19

22 the current deal, zero otherwise (No. of Arrangers). 11 We also incorporate an indicator variable reflecting whether a loan is issued during the recent financial crisis (Crisis), as borrowers typically have low bargaining power during periods of tight credit supply. 12 Further strengthening the Grace Period Hypothesis, the positive (negative) and significant coefficient on the No. of Arrangers (Crisis) variable suggests that borrowers with stronger bargaining power are more likely to obtain covenants that provide them with a grace period. Finally, in column 6, we incorporate a dummy variable reflecting whether a loan is issued by a relationship lender (Relationship). From its previous transactions with the borrower, a relationship lender typically has extensive knowledge of a borrower s operations and well developed channels of communication with its managers. Thus, in a relationship lending transaction, we do not expect borrowers to signal their quality via commitment to a tight trend. Consequently, a significant and negative effect of Relationship on the presence of the trend would support the Signalling Hypothesis. We find an insignificant coefficient on the Relationship variable, further suggesting that signalling is an unlikely explanation for the presence of this covenant feature. Across all the empirical tests presented in Panel A, we also find that a tight threshold trend is more likely for the loans of smaller borrowers and borrowers with lower tangibility. These variables are also likely to be associated with lower creditworthiness. Earnings volatility is insignificantly related to Tight Dummy; while higher volatility indicates higher riskiness, lenders may be reluctant to impose covenants with a tight trend on firms with volatile earnings because it can cause too frequent covenant violations. In untabulated analysis we also control for a 11 For these tests, by carefully reviewing lead arranger names on the DealScan database, we treat the different branches and subsidiaries of a given financial institution as the same lead arranger. 12 In untabulated analyses, we substitute the Crisis variable with the increase in the tightness of credit supply measure based on in the Federal Reserve Board s quarterly Senior Loan Officer Opinion Survey on Bank Lending Practices (e.g., Bassett et al. 2012). Similarly to the tabulated analyses, we find that the likelihood of the tight trend variable is decreasing in the periods of tight credit supply. 20

23 borrower s credit rating at loan origination when the data is available; we find similar results. In another robustness test, we control for the tightness (slack) of the initial covenant threshold. We employ both the Dichev and Skinner (2002) and Demiroglu and James (2010) measures and find that our results and inferences are unchanged. 13 However, it is important to emphasize that while we measure the covenant slack by taking into account the most common adjustments to covenant variables as documented by Li (2012), the slack of earnings-based covenants can only be estimated with substantial measurement error. In addition to substantial adjustments to GAAP numbers made by lenders when defining covenant thresholds (Leftwich, 1983, Dichev and Skinner, 2002), these adjustments often vary both across different covenants in the same contract and across different contracts, which requires tracking the precise definition of each covenant. 14 In Panel B of Table 5, we extend the analysis and focus on the sub-sample of loans with a tight trend and examine the determinants of the trend s steepness (Slope). We find that the "speed" with which the covenant thresholds become more restrictive is higher for borrowers with lower profitability and operating cash flows and for those experiencing losses. We interpret this evidence as suggesting that a relatively more inferior financial performance among borrowers that receive tight trend covenants is associated with a quick acceleration of the threshold values. Thus, while these borrowers are provided with a grace period, lenders require a more rapid improvement in their financial performance. 13 The first measure is estimated as the distance between the covenant variable and the initial threshold value, scaled by the standard deviation of the covenant variable over the previous quarters. The second measure is based on the borrower s covenant slack choice relative to the choices of borrowers with similar covenant slack choice sets. 14 For example, benchmark GAAP variables such as EBITDA and EBIT are typically adjusted by adding various items, such as depreciation and amortization expenses or other non-cash expenses, and by subtracting items such as non-cash income, capital expenditures, taxes paid, stock repurchase or other cash distributions. Even if precise covenant definitions are hand-collected from the contracts, some adjustments are not replicable, as the detailed data required for their estimation is not available in publicly available financial statements. 21

24 4.3. A tight threshold trend and changes in future financial performance A borrower s need for a grace period may be driven not only by its low financial performance at loan origination, but also by an expected deterioration in its initial performance following the loan issuance. In contrast, if borrowers commit to covenants with a tight trend to signal their quality, we would expect the tight trend feature to be associated with a strong improvement in performance following a loan issuance. Thus, looking at future financial performance may provide additional insights on the validity of two alternative explanations for the presence of a tight threshold trend on a loan s covenants. In Table 6 we present univariate examination of the changes in borrower s performance. Over the first year over the loan issuance, borrowers with a tight trend experience a decrease in profitability and interest coverage ratio and an increase in the debt to cash flow ratio (Panel A). Over the second and third year following a loan s issuance (Panels B and C), their interest coverage and debt to cash flow ratios improve, while these indicators continue to deteriorate for the benchmark group of borrowers. We report multivariate analyses of the relation between future performance changes and a tight trend feature in Table 7 by estimating the following OLS model:,. (2) Financial Performance is one of the three measures of borrower future performance profitability (Profitability), the interest coverage ratio (Interest Coverage) and the Debt to EBITDA ratio. We measure Profitability as EBITDA scaled by total assets (instead of the ratio based on income before extraordinary items) to avoid a mechanical relation between future profitability and a loan s interest spread. In untabulated analyses, we also examine the 22

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